MUTUAL FUNDS

Overall Roadmap
◦ Types of Investment Companies
◦ Mutual funds:
◦ Functions
◦ Investment styles
◦ Investment costs
◦ Performance
◦ Sources of information
Investment Companies
◦ Pool funds of individual investors and invest in a wide range of securities
or other assets
Unit Investment
◦ Services provided:
Trusts
◦ Record keeping and administration
◦ Diversification and divisibility Managed
◦ Professional management Investment
Investment
◦ Lower transaction costs Companies
Companies
Other
Investment
Organizations
Unit Investment Trusts
◦ https://www.investopedia.com/terms/u/uit.asp
Mutual funds
◦ https://www.investopedia.com/terms/m/mutualfund.asp
◦ A mutual fund is both an investment and an actual company. This may seem strange, but it is actually no
different than how a share of AAPL is a representation of Apple, Inc. When an investor buys Apple stock,
he is buying part ownership of the company and its assets. Similarly, a mutual fund investor is buying
part ownership of the mutual fund company and its assets. The difference is Apple is in the business of
making smartphones and tablets, while a mutual fund company is in the business of making investments.

◦ Mutual funds pool money from the investing public and use that money to buy other securities, usually
stocks and bonds. The value of the mutual fund company depends on the performance of the securities it
decides to buy. So when you buy a share of a mutual fund, you are actually buying the performance of its
portfolio.
Open end and closed end mutual funds
◦ https://www.investopedia.com/terms/o/open-endfund.asp
◦ https://www.investopedia.com/terms/c/closed-endinvestment.asp
Investment Companies
◦ Managed Investment Companies
◦ Open-End
◦ Issues shares when investors buy; redeems shares when investors cash out
◦ Priced at Net Asset Value (NAV)
◦ Closed-End
◦ Shares outstanding constant; investors cash out by selling to new investors
◦ Priced at premium or discount to NAV

◦ Other Investment Companies

◦ Hedge Funds
Net Asset Value
◦ Net Asset Value (NAV):
◦ Calculation:

Market Value of Assets  Liabilities

Shares Outstanding
Mutual Funds: Investment Styles
◦ Managed Investment Companies
 Open-End a.k.a. Mutual Funds
Money Market
Equity
Sector
Bond
International
Balanced and Fund of Funds
Asset Allocation and Flexible
Index
 Closed-End
Table 4.1 U.S. Mutual Funds by
Investment Classification (1 of 2)
Source: Investment Company Institute, 2016 Investment
Company Fact Book.
Costs of Investing in Mutual Funds
◦ Fee Structure:
1. Operating expenses
2. Front-end load
3. Back-end load
4. 12 b-1 charge
◦ Fees must be disclosed in the prospectus
◦ Share classes with different fee combinations
Operating expenses

◦ It costs money to run a mutual fund. Some funds cost more to operate than others. Regardless of the cost,
all mutual funds have a fee referred to as an expense ratio, or sometimes called a management fee or an
operating expense. This fee is deducted from the total assets of the fund before your share price is
determined.

◦ Example: Let’s say you own a mutual fund that is valued at $10 per share. It has a gross return of 10%,
meaning its total investment return was $1 per share. If there were no fees, the fund share would be
valued at $11, but the fund manager deducts 1% in fees, so your actual investment return is .89 cents
instead of the full $1, and after fees, your share is worth $10.89.

◦ Source: https://www.thebalance.com/mutual-fund-fees-to-ask-about-2388528
Front-end load and Back-end load

◦ When you buy an “A share” mutual fund, you will pay a commission when you purchase the shares. This
type of fee is sometimes referred to as a sales charge or a "front-end load." Thus a "no-load" fund has no
such upfront fee.

◦ When you buy a “B share” mutual fund, if you sell shares of your fund within a specified time frame you
will pay a redemption fee, also referred to as a "back-end load," a contingent deferred sales charge, or a 
surrender charge.
12 b-1 charge

◦ Many funds have an ongoing service or marketing fee, also called a 12(b)1 fee, which is paid to a
financial advisor or financial services company as compensation for marketing the fund.

◦ If you purchase a “C share” mutual fund it will typically have an extra 1% 12(b)1 fee, in addition to an
expense ratio. Just like the expense ratio, this service fee will be deducted out of the total fund assets
before your share price is determined.
Source: https://ptmoney.com/mutual-fund-prospectus/
Classes of Mutual Fund Shares

◦ Class C shares are a type of mutual fund shares. Mutual fund shares are divided up into three classes:
Class A shares, Class B shares, and Class C shares. Each class of mutual fund shares is distinguished by
their specific load fees and structures.

◦ The main difference between Class C shares and the other two mutual fund share classes is that Class C
shares are level-load. This means the total amount of money the investor pays to the mutual fund is
invested in shares. Instead of paying a percentage of the initial investment as a commission, the investor
pays the mutual fund commissions via annual fees.
◦ Class A shares charge the expense ratio, the 12b-1 fees, and  front-end load: best for investors who can
afford a high initial investment and have a long time horizon  
◦ Class B shares charge the expense ratio, the 12b-1 fees, and a back-end load: best for investors with little
cash to invest and have a long time horizon
◦ Class C shares charge the expense ratio, a back-end load if you withdraw / redeem your capital within the
first year, and the 12 b-1 fee: best for investors who have a short time horizon and plan on redeeming
their shares soon

◦ Source: https://www.investopedia.com/ask/answers/061515/how-are-mutual-funds-c-shares-different-and-b-shares.asp
Example 4.2 Fees for Various Classes
◦ The table below lists fees for different classes of the Dreyfus High Yield Fund in 2016. Notice the trade-off between the
front-end loads versus 12b-1 charges in the choice between Class A and Class C shares. Class I shares are sold only to
institutional investors and carry lower fees.

Class A Class C Class I

Front-end load 0-4.5%a 0 0

Back-end load 0 0-1%b 0%b

12b-1 feesc 0.25% 1.0% 0%

Expense ratio 0.7% 0.7% 0.7%

a Depending on size of investment.

b Depending on years until holdings are sold
c Including service fee.
Fees and Mutual Fund Returns
NAV1  NAV0  Income  Capital Gain
R
NAV0
◦ Example:
◦ Initial NAV = $20   𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝑁𝐴 𝑉 𝑡 =
◦ Income distributions of $.15 𝑆h𝑎𝑟𝑒𝑠𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
◦ Capital gain distributions of $.05
◦ Ending NAV = $20.10

$20.10  $20.00  $.15  $.05

R  .015 or 1.5%
$20.00
Exchange Traded Funds
◦ Definition: offshoots of mutual funds that allow investors to trade index portfolios just as they do shares of stock. Unlike
mutual funds which could be bought or sold only at the end of the day when NAV is calculated, investors can trade ETFs
sush as “spiders” throughout the day, just like any other share of stock.

◦ Examples: “spiders, Standard and Poor’s Depository Receipt, a unit investment trust holding a portfolio matching the
S&P 500 index” “diamonds, based on Dow Jones,” and “cubes, based on Nasdaq”

◦ Potential advantages:
◦ Trade continuously like stocks
◦ Can be sold short or purchased on margin
◦ Lower costs
◦ Tax efficient
◦ Potential disadvantages:
◦ Prices can depart from NAV
◦ Must be purchased from a broker
Figure 4.2 Growth of U.S. ETFs over
Time
Figure 4.3 Investment Company Assets
Under Management, 2015 ($ Billion)
Mutual Fund Investment Performance
◦ Performance of actively managed funds:
◦ Lagged Wilshire index in 27 of the 45 years (1971-2015)
◦ Evidence for persistent superior performance is weak, but suggestive
◦ Bad performance is more likely to persist
Diversified Equity Funds versus Wilshire 5000 Index: Rates of return on actively
managed equity funds versus Wilshire 5000 index,1971-2015
Information on Mutual Funds (1 of 2)
◦ Fund’s prospectus describes:
◦ Investment objectives
◦ Fund investment adviser and portfolio manager
◦ Fees and costs
◦ Statement of Additional Information (SAI)
◦ Fund’s annual report
Information on Mutual Funds (2 of 2)
◦ Morningstar
◦ Yahoo
◦ Investment Company Institute
◦ Directory of Mutual Funds
Mutual fund in industry
◦ https://money.usnews.com/funds/mutual-funds/industrials/vanguard-industrials-index-fund/vinax
◦ https://money.usnews.com/funds/mutual-funds/industrials/fidelity-select-defense-aero-port/fsdax
◦ https://www.morningstar.com/our-picks.html
Mutual fund research
◦ Kacperczyk and Seru, JF(2007):
“…We argue that the precision of relevant private information is related to managerial skills… The main
implication of our model is that portfolio holdings of skilled managers are less sensitive to changes in
information in the public domain.”

◦ They generate an empirical measure, RPI, which measures the mutual fund manager reliance on public
information, and find a negative relation between the empirical measure and the mutual fund’s future
performance.
Regression results: the relation between the reliance on public
information measure and the mutual fund’s future performance