FUNDAMENTALS

OF INVESTMENTS
-MUTUAL FUNDS

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Mutual Funds
 Mutual Funds

• Our goal in this chapter is to understand the different types of

mutual funds, their risks, and their returns.

• Around 1980, 5 million Americans owned mutual funds.

• However, by 2001, 93 million Americans in 55 million households

owned mutual funds.

• In 2001 investors added $505 billion in net new funds to mutual

funds.

• In 2001, mutual fund assets totaled $7 trillion.

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 Mutual Funds

• Mutual funds are simply a means of combining or pooling the

funds of a large group of investors.

• The buy and sell decisions for the resulting pool are then made
by a fund manager, who is compensated for the service provided.

• Like commercial banks and life insurance companies, mutual

funds are a form of financial intermediary.

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 Investment Companies and Fund Types

• An Investment company is business that specializes in pooling

funds from individual investors and making investments.

• An Open-end fund is an investment company that stands ready

to buy and sell shares in itself to investors, at any time.

• A Closed-end fund is an investment company with a fixed

number of shares that are bought and sold by investors, only in
the open market.

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Investment Companies and Fund Types

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 Investment Companies and Fund Types

• Net asset value (NAV) is the value of the assets held by a

mutual fund, divided by the number of shares.

• Shares in an open-end fund are worth their NAV, because the

fund stands ready to redeem their shares at any time.

• In contrast, share value of closed-end funds may differ from their

NAV.

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 Mutual Fund Operations
Organization and Creation

• A mutual fund is simply a corporation. It is owned by

shareholders, who elect a board of directors.

• Most mutual funds are created by investment advisory firms (say

Fidelity Investments), or brokerage firms with investment advisory
operations (say Merrill Lynch).

• Investment advisory firms earn fees for managing mutual funds.

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 Mutual Fund Operations
Taxation of Investment Companies

• A “regulated investment company” does not have to pay taxes on

its investment income.

• To qualify, an investment company must:

– Hold almost all its assets as investments in stocks, bonds, and
other securities,
– Use no more than 5% of its assets when acquiring a particular
security, and
– Pass through all realized investment income to fund
shareholders

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 Mutual Fund Operations
The Fund Prospectus and Annual Report

• Mutual funds are required by law to supply a

prospectus to any investor who wishes to purchase
shares.

• Mutual funds must also provide an annual report to

their shareholders.

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 Mutual Fund Costs and Fees
Types of Expenses and Fees

• Sales charges or “loads”

– Front-end loads are charges levied on purchases.
– Back-end loads are charges levied on redemptions.

• 12b-1 fees. SEC Rule 12b-1 allows funds to spend up to 1% of fund

assets annually to cover distribution and marketing costs.

• Management fees:
– Usually range from 0.25% to 1.00% of the funds total assets each year.
– Are usually based on fund size and/or performance.

• Trading costs
– Not reported directly
– Funds must report "turnover," which is related to the amount of trading.
– The higher the turnover, the more trading has occurred in the fund.
– The more trading, the higher the trading costs.

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 Mutual Fund Costs and Fees
Expense Reporting

• Mutual funds are required to report expenses in a fairly

standardized way in their prospectus.
– Shareholder transaction expenses - loads and deferred
sales charges.
– Fund operating expenses - management and 12b-1 fees,
legal, accounting, and reporting costs, director fees.
– Hypothetical example showing the total expenses paid by
investors through time per $10,000 invested.

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Example: Fee Table

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 Mutual Fund Costs and Fees
Why Pay Loads and Fees?

• After all, many good no-load funds exist.

• But, you may want a fund run by a particular manager. All such
funds are load funds.

• Or, you may want a specialized type of fund.

– Perhaps one that specialized in Italian companies
– Loads and fees for specialized funds tend to be higher, because
there is little competition among them.

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 Short-Term Funds, I.

• Short-term funds are collectively known as money

market mutual funds.

• Money market mutual funds (MMMFs) are mutual

funds specializing in money market instruments.
– MMMFs maintain a $1.00 net asset value to make them
resemble bank accounts.
– Depending on the type of securities purchased, MMMFs can
be either taxable or tax-exempt.

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 Short-Term Funds, II.

• Most banks offer what are called “money market”

deposit accounts, or MMDAs, which are much like
MMMFs.

• The distinction is that a bank money market account is

a bank deposit and offers FDIC protection.

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 Long-Term Funds

• There are many different types of long-term funds, i.e.,

funds that invest in long-term securities.

• Historically, mutual funds were classified as stock funds,

bond funds, or income funds.

• Nowadays, the investment objective of the fund is the

major determinant of the fund type.

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 Stock Funds, I.

• Some stock funds trade off capital appreciation and dividend

income.
– Capital appreciation
– Growth
– Growth and Income
– Equity income
• Some stock funds focus on companies in a particular size range.
– Small company
– Mid-cap
• Some stock fund invest internationally.
– Global
– International
– Region
– Country
– Emerging markets

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 Stock Funds, II.

• Sector funds specialize in specific sectors of the economy, such

as:
– Biotechnology
– Internet
– Energy
• Other fund types include:
– Index funds
– Social conscience, or “green,” funds
– “Sin” funds (i.e., tobacco, liquor, gaming)
– Tax-managed funds

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 Bond Funds
• Bond funds may be distinguished by their
– Maturity range
– Credit quality
– Taxability
– Bond type
– Issuing country

• Bond fund types include:

– Short-term and intermediate-term funds
– General funds
– High-yield funds
– Mortgage funds
– World funds
– Insured funds
– Single-state municipal funds

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 Stock and Bond Funds

• Funds that do not invest exclusively in either stocks or bonds are

often called “blended” or “hybrid” funds.

• Examples include:
– Balanced funds
– Asset allocation funds
– Convertible funds
– Income funds

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 Mutual Fund Objectives:
Recent Developments, I.

• A mutual fund “style” box is a way of visually

representing a fund’s investment focus by placing the
fund into one of nine boxes:

Style
Value Blend Growth
Large
Size

Medium
Small

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 Mutual Fund Objectives:
Recent Developments, II.

• In recent years, there has been a trend toward classifying a

mutual fund’s objective based on its actual holdings.

• For example, the Wall Street Journal classifies most general

purpose funds based on the market “cap” of the stocks they hold,
and also on whether the fund tends to invest in “growth” or
“value” stocks (or both).

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Mutual Fund Objectives

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 Mutual Fund Performance

• Mutual fund performance is very closely tracked by a

number of organizations.
• Financial publications of all types periodically provide
mutual fund data.
• The Wall Street Journal is particularly timely print
source.
• www.morningstar.com has a “Fund Selector” that
provides performance information

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Mutual Fund Performance

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Mutual Fund Performance

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 Mutual Fund Performance

• While looking at historical returns, the riskiness of the

various fund categories should also be considered.

• Whether historical performance is useful in predicting

future performance is a subject of ongoing debate.

• Some of the poorest-performing funds are those with

very high costs.

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 Closed-End Fund Performance

• A closed-end fund has a fixed number of shares.

• These shares are traded on stock exchanges.

– There are about 450 closed-end funds that have their shares
listed on U.S. Stock Exchanges.
– There are about 7,000 long-term open-end mutual funds.

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Mutual Fund Performance

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 The Closed-End Funds Discount

• Most closed-end funds sell at a discount relative to

their net asset values.
– The discount is sometimes substantial.
– The typical discount fluctuates over time.

• Despite a great deal of academic research, the closed-

end fund discount phenomenon remains largely
unexplained.

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 Exchange Traded Funds

• An exchange traded fund, or ETF,

– Is basically an index fund.
– Trades like a closed-end fund (without the discount phenomenon).

• An area where ETFs seem to have an edge over the more

traditional index funds is the more specialized indexes.

• A well-known ETF is the “Standard and Poor’s Depositary

Receipt” or SPDR.
– This ETF mimics the S&P 500 index.
– It is commonly called “spider."

• A list of ETFs can be found at www.amex.com.

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 Hedge Funds

• Like mutual funds, hedge funds collect pools of money from

investors. However,
– Hedge funds are not required to register with the SEC.
– Hedge funds are not required to maintain any particular degree of
diversification or liquidity.
– Hedge fund investors must qualify as “financially sophisticated”
investors.
• Hedge fund managers have considerable freedom to follow
various investment strategies, or styles.
• Hedge fund fees:
– General management fee of 1-2% of fund assets
– Performance fee of 20-40% of profits

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 Useful Internet Sites

• www.ici.org (reference for mutual fund facts and figures)

• www.vanguard.com (example of major fund family website)
• www.fidelity.com (website of largest investment advisory firm in US)
• www.ipsfunds.com (reference for “plain language” risk disclosure)
• www.mfea.com (reference for info on thousands of funds)
• www.morningstar.org (reference for one of the best mutual fund sites)
• www.vicefund.com (reference for “vice” funds)
• www.socialinvest.org (reference for “social conscience” funds)
• www.hedgefundworld.com (reference for hedge fund information)
• www.turnkeyhedgefunds.com (reference to start your own hedge fund)

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 Chapter Review, I.
• Investment Companies and Fund Types
– Open-End versus Closed-End Funds
– Net Asset Value
• Mutual Fund Operations
– Mutual Fund Organization and Creation
– Taxation of Investment Companies
– The Fund Prospectus and Annual Report
• Mutual Fund Costs and Fees
– Types of Expenses and Fees
– Expense Reporting
– Why Pay Loads and Fees?
• Short-Term Funds
– Money Market Mutual Funds
– Money Market Deposit Accounts

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 Chapter Review, II.
• Long-Term Funds
– Stock Funds
– Taxable and Municipal Bond Funds
– Stock and Bond Funds
– Mutual Fund Objectives: Recent Developments

• Mutual Fund Performance

– Mutual Fund Performance Information
– How Useful are Fund Performance Ratings?

• Closed-End Funds and Exchange Traded Funds

– Closed-End Funds Performance Information
– The Closed-End Fund Discount Mystery
– Exchange Traded Funds

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