Mutual Funds: An Indirect Route to the Market

Gitman-Joehnk

Chapter 13

Key Concepts

• Distinction between investing in a mutual fund and investing directly in securities

• pooled diversification

• closed-end vs.open-end funds

• load Vs.. no-load funds

• 12(b)-1 fees and other charges

• classification of mutual fund types by fund objectives

• variety of fund services available to investors

• choosing funds consistent with investment objectives

• computing the holding period return and approximate yield of a mutual fund

I. Mutual funds allow investors to own securities indirectly

A. Mutual fund as a financial intermediary

1. Key benefits include

pooled diversificationprofessional managementlow initial investmentspecial services such as automatic

reinvestment of dividends

2. Key drawbacks include:

load charge (may reduce front-endcontributions)

management fees of from .5 to 1.75%(or higher) are common

performance has not been better thanmarket averages

B. Each mutual fund has several contributors:

1. management company - usually the fund’screator

2. investment advisor - usually an employeeof the mgt. co.

3. distributor - sells the mutual fund shares to the public

4. custodian - safeguards fund assets and securities, usually a bank or trust co.

5. transfer agent - maintains shareholderrecords

C. Classification and Characteristics of Mutual Funds

1. open-end investment cos. are true mutualfunds-account for 90% of all MF assets-have no limit on the number of issued

shares -purchase and sale of MF shares are

made with the MF-current market value or

net asset value,( NAV), plusany commissions representsthe purchase or sale price ofa MF share

2. Closed-end funds operate with a fixednumber of shares outstanding

-have a capital structure like ordinarycorporation

-shares trade in the market for commonstock

-CEF shares often trade at a discountto (occasionally at a premium)NAV

3. unit investment trust - holds a portfolio of securities which, once selected, is

unmanaged

-portfolio is assembled and shares sold-portfolio is usually bonds of 10 to 15

years maturity-income is paid periodically and the trust

is liquidated when the securitiesmature

4. Load funds - charge a commissionfor the purchase(front-end)and/orsale or redemption (back-end) of MFshares

-brokers prefer to sell load fundsinvestors may need to contactno-load funds on their own

-commissions of 7 to 8.25% are common-performance of load funds has been

no better than that of no-load MFs-low-load funds are now appearing-some funds also charge a 12(b)-1 annual

assessment for marketing anddistribution expenses

5. No-load funds do not charge a commissionfor the purchase or sale of MF shares

-some do charge 12(b)-1 fees

6. All MF are subject to management feesof between .5 and 1.75% per year

-these charges are levied regardless ofthe fund’s performance

-commissions and security transactionstaxes also apply

-all expenses and costs associated withthe MF are required to be providedin an easy to read format

II. Major classification of Mutual Funds by Type

A. Based on MF Objectives

1. growth funds - objective is capital gainsviewed as long-term investmentvehicles for moderately aggressive investors who seek wealth accumulation

2. Aggressive growth (performance) funds - highly speculative MF, objective ishigh returns from capital gains.vehicles for aggressive investors willingto accept high risk

3. Equity income fund - primary objectiveis current income from interest and/or dividends.more conservative, with moderatelevel of risk

4. Balanced fund - objective is income andlong-term capital gainsmaintain higher % of funds inbonds than equity-income funds

5. Growth and income fund - objectivefocusing more on growth or capitalgains and less on current income

6. Bond funds - designated to generate income through investment in portfolios of variousbond issues.Focus on high quality government bonds,corporates, and/or municipals eliminatesmost default risk but interest rate riskremains.

7. Money Market Funds - offer ownership in a portfolio of short-term. money marketsecurities.Low risk, highly liquid investment funds

8. Index funds - buy and hold a portfolio of stocks or bonds equivalent tothe composition of a leading marketindexproduces market performance, asmeasured by that index, with lowmanagement costs

9. Sector funds - tend to limit their holdingsto one or more segments (industries)of the capital market

10. Asset Allocation funds - spread investors’ funds across stocks and bondsand money market securities Designed for investors who want to hirefund managers not only to selectindividual securities but also to makestrategic decisions on how to allocate money among the various sectors of themoney and capital markets

11. International funds - only acquire securities of foreign firms. A variant, the globalfund, would also include securities ofUS companies

III. Other Mutual Fund Services

A. Automatic investment and reinvestment plans

1. investor makes an agreement to investa certain amount with the fund eachperiod

2. dividend and /or capital gains income isused to purchase additional shares ofthe mutual fund

B. Withdrawal plans for regular income payments

1. may be fixed-dollar withdrawals

2. set number of shares to be liquidated each period

C. Conversion privileges for investors interested in changing among a variety of funds

1. at no or low cost, a family of MFs willallow an investor to transfer money among company funds

2. for tax purposes this represents a sale andpurchase so taxes will be due at that time

4. Retirement programs such as Keoghs andIRAs can be serviced by MFs

IV. Approach to MF Investing

A. 3 Common investment uses of MF

1. accumulation of wealth for future needs

2. storehouse of value, i.e..... MFs allow forthe preservation of capital and current income-particularly attractive

3. speculation and short-term trading not a common use due to long-termnature of MF investing

B. Selection of specific MFs out of 6,000+ available

1. examine fund specifics (many eliminated)

-investment objectives-intended use of fund -range of services offered-manner of fund operation-historical performance of fund

should provide a small set of MF that haveobjectives, performance, and services that are reasonably consistent with the investor’s preferences

2. final step is elimination of funds bycloser comparison of costs andperformance

returns over timeperformance in up and down marketsload Vs.. no-loadmanagement feeslevels of dividends and capital gains

distributionsconsistency of management

V. Rates of Return and Investment Performance of MF

A. ROR on MF are just as important as for individual investments

1. sources of returns dividend incomecapital gains distributionschanges in MF share price or NAV

2. for open-ended funds the price of a MFshare and NAV are the sameexcept for commissions

3. for close-ended funds the price and NAV may not be equal

P>NAV premiumP<NAV discount, most likely

changes in the premium ordiscount are a source of returnunique to CEFs

changes in the premium or disc.for a CEF are reflected in theprice of the CEF fund

B. Computing Returns on MF

1. HPR - holding period return for MF performance

assume all current income and capitaldistributions occur within the same year

HPR div. rec.+cap.gains dist.+fund price(yr.end) - fund price(bg. yr)fund price (bg. yr.)

HPR measure appropriate if all distributions arereinvested in the fund:

HPR

(ending # of shares ending price) - (begin. # shares begin. price)(begin. # of shares begin. price)

HPR is not appropriate if performance is to be measured over a period exceeding a year.

Approximate yield is a better measure.

AY total avg. annual invome +

ending share price - begin. share pricenumber of years held

ending share price + begin. share price2

Most MF are diversified and have reduced or eliminated buiness and financial risk.

MFs still face market risk

the MF’s mgt. practices may affect the fund’s level of risk

MFs face interest rate risk, most importantlyfor MF with bonds in their portfolio

Securities in the portfolio are still subject tointerest rate ris, market risk andpurchasing power or inflation risk.