Chapter 21

The Mutual Fund Industry

Mutual Funds
• Mutual funds pool the resources of many small investors by selling them shares and using the proceeds to buy securities.
– The diversification benefits and potential cost savings are the primary benefits of mutual funds

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The Growth of Mutual Funds
• At the beginning of 2007, nearly 16% of assets held by intermediaries were held by mutual funds. • 25% of the retirement market and almost 50% of all U.S. households hold stock via mutual funds. • Assets held by mutual funds have grown by over 17.5% per year for the last 20 years, reaching over $10 trillion by 2007.
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The Growth of Mutual Funds
• The first mutual fund similar to the funds of today was introduced in Boston in 1824. • The stock market crash of 1929 set the mutual fund industry back because small investors avoid stocks and distrusted mutual funds. • The Investment Company Act of 1940 reinvigorated the industry by requiring better disclosure of fees, etc.
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The Growth of Mutual Funds
• There are five principal benefits of mutual funds:
1. Liquidity intermediation: investors can quickly convert investments into cash while still allowing the fund to invest for the long term.

2. Denomination intermediation: investors can participate in equity and debt offerings that, individually, require more capital than they possess.
3. Diversification: investors immediately realize the benefits of diversification even for small investments.

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The Growth of Mutual Funds
• There are five principal benefits of mutual funds:
4. Cost advantages: the mutual fund can negotiate lower transaction fees than would be available to the individual investor. 5. Managerial expertise: many investors prefer to rely on professional money managers to select their investments. NOTE: I would add reliable information to this list
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The Growth of Mutual Funds
• Ownership in mutual funds has changed dramatically over the last 20 years
– In 1980, only 5.7% of households held mutual fund shares

– In the beginning of 2007, that number was 48%
– Mutual funds account for $4.1 trillion of the retirement market (estimated at $16.4 trillion)

The following slides show the time series of these trends.
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Trends in Assets Held by FIs

The Growth of Mutual Funds

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Mutual Funds As Retirement Assets

Source: Investment Company Institute

Mutual Fund Structure
• Prior to the 1980’s, broker-sold funds dominated • During the 1980’s & early 1990’s, fund families became very important and independent no-load funds got traction • When Schwab introduced the “mutual fund marketplace” the game changed
– Independent funds flourished – No-load funds flourished – The “family” no longer so important
Mutual fund fact book http://www.ici.org/aboutfunds/factbook_toc.html 21-15

Mutual Fund Structure
• Closed-End Fund: a fixed number of nonredeemable shares are sold through an initial offering and are then traded in the OTC market. Price for the shares is determined by supply and demand forces. • Open-End Fund: investors may buy or redeem shares at any point, where the price is determined by the net asset value of the fund.
– All trades are in the primary market (direct with fund itself)
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Mutual Fund Structure
• Exchange-traded fund (ETF): In some ways a hybrid between the closed-end and open-end structures
– Trades OTC all day like closed end – Usually based on fairly liquid assets like open-end – Arbitrage mechanism avoids big gaps between trade prices and NAV – Tax advantages – Pay commission + bid/ask to trade – Nearly all are index funds
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Calculating a Mutual Fund’s Net Asset Value
• Net Asset Value (NAV)

• Definition: Total value of the mutual fund’s stocks, bonds, cash, and other assets minus any liabilities such as accrued fees, divided by the number of shares outstanding
Stocks Bonds Cash Total value of assets Liabilities Net worth Outstanding shares
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$35,000,000 $15,000,000 $3,000,000 $53,000,000 -$800,000 $52,200,000 15 million
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NAV = $52,200,000/15,000,000 = $3.48

Mutual Fund Structure: the Organization • The shareholders, or owners, of the mutual fund are the investors. • The board of directors oversees the fund’s activities, hires the investment advisor, an underwriter, etc., to manage the day to day operations of the fund.

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Mutual Fund Structure: the Organization

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Mutual Fund Business Functions
Product Design Investment Management

Processing Distribution Investors

Mutual Fund Structure: the Organization
• In theory, the board can fire the fund manager and hire anyone they choose. For instance, the board for the Fidelity Magellan Fund can fire Fidelity. Of course, if the board hires a nonFidelity management team, the fund will probably lose its name, and possibly its reputation along with it.

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Investment Objective Classes
• There are four primary classes of mutual funds available to investors:
1. Stock (equity) funds 2. Bond funds 3. Hybrid funds (balanced funds) 4. Money market funds

• The next slide shows the distribution of assets among these different classes.
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Investment Objective Classes

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Investment Objective Classes - Bonds

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Investment Objective Classes
• Hybrid Funds
– Combine stocks and bonds into a single fund. – Account for about 6% of all mutual fund accounts.

• You will more often hear these referred to as “balanced funds”

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Investment Objective Classes
• Money Market Mutual Funds
– Open-end funds that invest only in money market securities. – Offer check-writing privileges. – Net assets have grown dramatically, as seen in the next slide. – Almost always have a $1 NAV
• Breaking the buck (Reserve MM Fund)
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Investment Objective Classes

Investment Objective Classes
• Money Market Mutual Funds
– Although money market mutual funds offer higher returns than bank deposits, the funds are not federally insured. – The next slide shows the distribution of assets in MMMF, which are relatively safe assets.

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Investment Objective Classes

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Investment Objective Classes
• Index Funds
– A special class of mutual funds that do fit into any of the categories discussed so far. – The fund contains the stock of the index it is mimicking. For example, an S&P 500 index fund would hold the equities comprising the S&P 500. – Offers benefits of traditional mutual funds without the fees of the professional money manager.
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Marketing Fee Structure of Investment Funds
• Load funds (class A shares) charge an upfront fee for buying the shares. No-load funds do not charge this fee. • Deferred load (class B shares) funds charge a fee when the shares are redeemed. • If the particular fund charges no front or back end fees, it is referred to as class C shares.

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Marketing Fee Structure of Investment Funds • Other marketing fees charges by mutual funds include:
– contingent deferred sales charge: a back end fee that may disappear altogether after a specific period. – redemption fee: another name for a back end load – 12b-1 fee: fee to pay marketing, advertising, and commissions.
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Other Mutual Fund Expenses
• Annual expenses include:
– Management fees – Custodial expenses – Shareholder servicing expenses – Auditing expenses – The aforementioned 12b-1 fee: fee to pay marketing, advertising, and commissions.

• These expenses are presented by any source of fund info (like Yahoo, Moneycentral, etc.)
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Regulation of Mutual Funds
• Mutual funds are regulated by four primary laws:
– Securities Act of 1933: specifies disclosure requirements – Securities Exchange Act of 1934: details antifraud rules – Investment Company Act of 1940: requires registration and minimal operating standards

– Investment Advisors Act of 1940: regulates fund advisors
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Regulation of Mutual Funds
• Mutual funds are the only companies in the U.S. that are required by law to have independent directors, as follows (2001 SEC rules)
– Independent directors must constitute a majority of the board – Independent directors select and nominate other independent directors

– Legal counsel to the independent directors must also be independent
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Hedge Funds
• A special type of mutual fund that have grown dramatically in recent years (although they backtracked in 2008). • Different from typical mutual funds, as follows:
– High minimum investment, averaging around $1 million – Long-term commitment of funds is required – High fees: typically 1% of assets plus 20% of profits – Highly levered – Little current regulation
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Hedge Funds
• Hedge funds are often trying to take advantage of unusual spreads between security prices

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Hedge Funds
• The SEC passed regulation in 2006 requiring hedge fund advisors to register with the SEC. The SEC became concerned about fraud, and hedge funds became available to the average investor via “retailization”.

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Estimated Growth of Assets / Net Asset Flow Hedge Fund Industry 1990 – Q1 2007
$1,600,000 $1,500,000 $1,400,000 $1,300,000 $1,200,000
$1,105,385 $1,568,400 $1,464,526

$1,100,000 $1,000,000
$972,608

Assets (In $MM)

$900,000
$820,009

$800,000 $700,000 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 $0
($1,141) $95,720 $58,370 $38,910 $8,463 $27,861 $367,560 $256,720 $185,750 $167,790 $167,360 $91,431 $36,918 $57,407 $14,698 $4,406 $55,340 $23,336 $46,545 $99,436 $70,635 $73,585 $625,554 $539,060 $490,580 $456,430 $374,770

$126,474 $46,907 $60,222

($100,000) 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Q1 2007

Estimated Assets

Net Asset Flow

Conflicts of Interest in the Mutual Fund Industry • Mutual Fund Abuses
– Late trading: allowing trades after 4:00 pm to trade at today’s 4:00 NAV instead of tomorrow’s price. This is illegal under SEC regulations. – Market timing: taking advantage of time zone differences for determination of NAV. This is not illegal under SEC rulings.
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Conflicts of Interest in the Mutual Fund Industry
• Government Response to Abuses
– Require more independent directors
– Hardening the 4:00 valuation rule: this addresses the late trading problem, but not market timing.

– Increased and enforces redemption fees: fees to discourage market timing by additional fees for shortterm redemptions.
– Increased transparency: hits operating practices, directors, investment managers, compensation arrangements with brokers, etc.
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