Post on 25-Dec-2015
transcript
Mutual Funds and Other
Investment Companies
Chapter 4
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
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4.1 Investment Companies
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Services of Investment Companies
a. Administration & record keeping
Tax purposes
Low cost reinvestment
Low cost additional investment, DCA
Low cost switching between fund families
Some funds may allow check writing privileges
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Services of Investment Companiesb. Diversification
c. Professional management
d. Reduced transaction costs
e. Investing for retirement: Most funds can be set up as an IRA
Lower research costs
Portfolio managed according to specific objectives
Professionals to find undervalued securities and/or engage in asset allocation strategies
Low cost, instant diversification
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4.2 Types of Investment Companies
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Organizational FormsUnit Investment Trusts (UITs): unmanaged, fixed composition portfolios
Any interest and/or dividends are distributed immediately to trust certificate holders.
Provide diversification within one sector or area and low cost entry.
Often levered, rates of return can be extreme.
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Organizational FormsA managed investment company (mutual fund) may be
Open end– shares are bought from the fund and redeemed by
the fund or
Closed end
– shares are bought and sold among investors in the marketplace (NASDAQ or an exchange) and the fund itself is not involved.
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Differences in Open & Closed EndMost funds are open end:
The advantage of the open end form is
The disadvantage of the open end form is
Liquidity for the investor
Fund’s ability to grow (advantage for the fund or sponsor)
The need to keep a cash reserve
Vulnerable to panics
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Other Investment Organizations
– Commingled funds• Partnerships of investors that pool their funds.
Designed for trusts or larger retirement accounts to get professional management for a fee. Operates similar to a mutual fund.
– REITs• Similar to closed end fund. Invest in real estate and
real estate loans.Equity trusts purchase real estate.
Mortgage trusts invest in mortgage and construction loans.
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Other Investment Organizations Cont.
– Hedge Funds• Similar to mutual funds, but not registered and
not subject to SEC regulations.• Available to institutional and high net worth
investors• Can pursue investment strategies that are not
allowed for mutual funds. – Grew from about $50 billion in 1990 to about $2
trillion in 2008.
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4.3 Mutual Funds
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Net Asset Value
Used as a basis for valuation of investment company shares– Selling new shares– Redeeming existing shares
Calculation
goutstandin shares Fund
sLiabilitie Fund AssetsFund of ValueMarketNAV
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Open-End and Closed-End Funds: Key Differences
Shares OutstandingClosed-end: no change unless new stock is
offeredOpen-end: changes when new shares are sold or
old shares are redeemed
PricingOpen-end: Fund share price = Net Asset Value
(NAV)Closed-end: Fund share price may trade at a
premium or discount to NAV
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NAV calculation
ABC Fund ($Millions except NAV)
Market Value Securities
+ Cash & Receivables
- Current Liabilities
NAV Total
# Fund Shares
NAV
$550.00
75.00
(20.00)
$605.00
20.00
$ 30.25
Most Mutual Funds have little or no Long Term Debt
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How Funds Are Sold
Directly marketed– –
•
Sales force distributed– – –
•
You find them
May avoid front end load
Front end load is an up front cost (fee) to purchase a share of a mutual fund.
Recommended by a broker or planner
Usually will have a front end load
May be revenue sharing on sales force distributed
Potential conflict of interest
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Potential Conflicts of Interest: Revenue Sharing
Brokers put investors in funds that may that ____________________________
Mutual funds could direct trading _____________________
Revenue sharing is _________ but it must be ________ to the investor
may not be the most appropriate
to higher cost brokers
not illegal
disclosed
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Different Funds based on Investment Objectives & Styles
1. Domestic Stock Funds
a. Aggressive Growth, Growth, Growth & Income, Value, etc
b. Large Cap, Mid Cap, Small Cap, etc
2. Index - passively managed
a. Borad market, Industry, International, etc
3. Fixed Income
a. Government(s), Corporate bonds, etc
4. International
a. Stocks, Bonds, Emerging Markets, etc
5. Money market funds
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Table 4.1 U.S. Mutual Funds by Investment Classification, 2008
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Trading Scandal with Mutual FundsLate trading:
allowing some investors to purchase or sell after NAV has been determined for the day
Market timing: allowing investors to buy or sell on stale net asset values– International: fund NAV may be based on prices in
foreign markets which close at different times. A U.S. mutual fund specializing in Japanese stocks may create an exploitable opportunity since the Japanese markets close before ours, at which time the fund’s NAV will be set.
If the U.S. markets subsequently go up late in the day, probably Japanese stocks will go up the next day, driving up NAV for the fund the next day.
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Potential ReformsStrict _____________ with late orders
executed the following trading day
________________ with net asset values being adjusted for trading in open markets
Imposition of __________________________________
4:00 PM cutoff
Fair value pricing
redemption fees on holdings < 1 week
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4.4 Costs of Investing in Mutual Funds
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Costs of Investing in Mutual FundsFee Structure
–
–
Operating expenses–
12 b-1 charges–
–
–
Front-end load
Back-end load (contingent), (redemption fee)
Buying and selling commissions, administrative expenses and advisory fees for the managers
Marketing costs paid by the fundholders
Alternative to a load, but assessed annually
Maximum is 1% of assets
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Costs of Investing in Mutual Funds
Fees, loads and performance– Gross performance of load funds is
statistically identical to gross performance of no load funds
– Why pay a load charge?
– Funds with high expenses tend to be poorer performers.
• 12 b-1 charges should be added to expense ratios• Costs found in the fund prospectus and may be
compared via Morningstar
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NAV and the Effective LoadCost to initially purchase one share of a load fund = NAV + front-end load (%) (if any).
Stated Loads typically range from ________ If you invest $10,000 in a fund with an 8.5% front-end load,
you actually acquire shares worth $9,150; the other $850 goes to the broker.
The load is designed to offset expenses of marketing the fund and goes to the broker who sells the fund to the investor.
The effective load is greater than the stated load: In the above example, the actual % commission cost (effective load) is:
– $850 / $9150 = 9.3%; which is > stated load.
0 to 8.5%
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Costs of Investing in Mutual Funds
Avoiding the load:– Can sometimes choose different class of
fund shares.
– Best alternative may depend on _______________________________________.amount invested and expected holding period
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Costs of Investing in Mutual FundsExpense ratios:Funds charge annual operating expenses and
annual advisory or management fees against the NAV.– Expense ratios are calculated as
Annual Expenses / Average NAV
– A "well managed" fund probably should have an expense ratio of less than ___.
All costs and charges must be revealed in the fund's prospectus.
2%
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Amount initially invested =
Amount after gross return =
Amount after fees =
Net rate of return =
In MF prospectus and annual reports the MF returns are net of operating expenses, 12b-1 fees and commissions, but the returns do not include loads.
Converting gross pretax returns to net pretax returns:
$10,000 – (0.06 x $10,000) = $9,400
$9,400 x 1.175 = $11,045
$11,045 - (0.0135 x $11,045) = $10,895.89*
($10,895.89 - $10,000) / $10,000 = 8.96%
ThisThis year you invested $10,000 in a mutual fund with a year you invested $10,000 in a mutual fund with a 6% load (one time fee) and estimated annual expenses of 6% load (one time fee) and estimated annual expenses of 1.35%. The gross return is 17.5%. What is your return 1.35%. The gross return is 17.5%. What is your return net of loads and expenses?net of loads and expenses?
* This example calculates expenses using ending NAV.
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HPR on mutual funds
Dist = Distribution
All distributions are taxable, even if reinvested in the fund.
Do not buy into a MF just before its distribution date (usually near the end of the year or quarter).
Buy
DistDistBuySell
NAV
DivCGNAVNAVHPR
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4.5 Taxation of Mutual Fund Income
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General Tax RulesThe fund itself is not taxed as long as
– Fund meets certain diversification requirements– Fund distributes virtually all income earned
(less fees and expenses) to fund shareholders
The investor is taxed on capital gain and dividend distributions at the investor’s appropriate tax rate.
Distribution requirements imply that portfolio turnover may affect an investor’s tax liability.
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Taxes and Mutual Funds
_______________________ can be structured to take advantage of taxes while mutual funds cannot
High turnover leads to _________________
More disclosure on taxes was required ________
Investor directed portfolios
greater tax liability
in 2002
After-tax returns now reported in prospectus
For more information on taxes see:
IRS Publication 564: Mutual Fund Distributions
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Implications of Fund Turnover
The fund itself pays commission costs on purchases and sales of portfolio holdings, which are charged against NAV. –
–
The turnover rate is measured as the ______________ _____________ in a year divided by the ____________ __________.
These commissions are lower than what you and I pay.
Total commission expenses are higher if the portfolio has higher turnover.
total asset valuebought or sold average totalasset value
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Implications of Fund Turnover
For example, if a fund had an average total asset value of $10 million, and $6 million of securities were bought or sold that year the turnover rate was ____
Can you figure the average security holding period from the turnover ratio?
Turnover rates vary from ______________ per year.< 5% to > 300%
Average holding period or AHP AHP = 0.5 x (1 / turnover ratio) AHP = 0.5 x (1 / 0.60) = 0.83 years
60%.
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4.6 Exchange Traded Funds
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Exchange Traded Funds
ETFs allow investors to trade index portfolios like shares of stock
Examples:
Potential advantages– – –
• •
–
Trade continuously throughout the day
Can be sold short or purchased on margin
Potentially lower taxes
No fund redemptions
Large investors can exchange their ETF shares for shares in the underlying portfolio
Lower costs (No marketing; lower fund expenses)
SPDRs and Diamonds, Cubes, WEBS
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Exchange Traded Funds
Potential disadvantages
Small deviations from NAV are possible
Must pay a brokerage commission to buy an ETF but a no load index fund may be purchased online for no commission.
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Table 4.3 ETF Sponsors and Products
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4.7 Mutual Fund Investment Performance: A First Look
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First Look at Mutual Fund Performance
Evidence shows that average mutual fund performance is generally ________ broad market performance
Evidence suggests that over certain horizons ________________ in positive performance– Evidence is _____________
–
less than
some persistence
not conclusive
Some inconsistencies
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4.8 Information on Mutual Funds
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Sources of Information on Mutual Funds
Wiesenberger’s Investment Companies Morningstar (www.morningstar.com) Fund prospectus (a must read) Yahoo Wall Street Journal Investment Company Institute (www.ici.org) AAII Brokers
Background information: “A Random Walk Down Wall Street,” by Burton Malkeil
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Figure 4.4 Morningstar Report
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Morningstar Report Cont.
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Sample Problems
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Problem 1
NAV is $10.70 Front-end load is 6%
Every dollar paid results in only ____ going toward purchase of shares.
Offer price =
$.94
NAV = 1 - load
$10.70 = 1-.06
$11.38
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Problem 2
Offer price $12.30 Front-end load is 5%
Every dollar paid results in only ____ going toward purchase of shares.
NAV =
= $12.30 x 0.95
= $11.69
$.95
offer price x (1- load)
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Problem 3
NAV = (Market Value of Assets – Liabilities) Shares Outstanding
A. (200,000)x($35) = $ 7,000,000
B. (300,000)x($40) = $12,000,000
C. (400,000)x($20) = $ 8,000,000
D. (600,000)x($25) = $15,000,000 $42,000,000
$42,000,000 – $30,000 = $10.49 = NAV4,000,000
Shares Outstanding
4,000,000
Liabilities
$30,000
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Problem 4
Turnover rate = Value of stocks sold and replaced Market Value Assets
Value of stocks sold = (600,000x$25)= $15,000,000 or
Value of stocks purchased = (200kx$50)+(200kx$25) = $15,000,000
$15,000,000 = 0.357 or 35.7%$42,000,000
Average holding period?
Market Value Assets = $42,000,000
AHP = 0.5 x 1/Turnover
= 0.5 x 1/0.357 = 1.4 yrs
MVA = $42M
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Problem 5
a. The empirical research suggests that past performance is not highly predictive of future performance, especially for better performing funds. There may be some tendency for the fund to perform better than average next year, but it is unlikely that the fund will be in the top 10%.
b. Evidence suggests that bad performance is more likely to persist. Probably related to high fund costs or high turnover rates. Excessive costs are detrimental to a
fund’s returns.
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Problem 6
As an initial approximation, your return equals the return on the shares minus the total of the expense ratio and purchase costs:– Return 12% 1.2% 4% = 6.8%
But the precise return is less than this because the 4% load is paid up front, not at the end of the year.
To purchase the shares, you would have had to invest:– $20,000 / (1 0.04) = $20,833
The shares net increase in value (12% 1.2%) from $20,000 to: – $20,000 (1.12 0.012) = $22,160
The rate of return is:
($22,160 $20,833) / $20,833 = 6.37%
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Problem 7
a. Sell after 4 years: Suppose you have $1000 to invest. The initial investment in Class A shares is ____ net of the front-end load. After 4 years, your portfolio will be worth:
$940 (1.10)4 = $1,376.25
Class B shares allow you to invest the full $1,000, but your investment performance net of 12b-1 fees will be only 9.5%, and you will pay a 1% back-end load fee if you sell after 4 years.
Your redemption value after 4 years will be:
$1,000 (1.095)4 x 0.99 = $1,423.28
Class B shares are the better choice if your horizon is 4 years.
$940
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Problem 7 Cont.
b. Sell after 15 years:
With a 15-year horizon, the Class A shares will be worth:
$940 (1.10)15 =
For the Class B shares, there is no back-end load in this case since the horizon is greater than 5 years. Therefore, the value of the Class B shares will be:
$1,000 (1.095)15 =
At this longer horizon, Class A shares are the better choice. Why?
$3,926.61
$3,901.32
N x LN [1.10 / 1.095]N x LN [1.10 / 1.095]
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Problem 8
Suppose that finishing in the top half of all portfolio managers is purely luck, and that the probability of doing so in any year is exactly 50%.
Then the probability that any particular manager would finish in the top half of the sample five years in a row is 0.505 = 0.03125.
We would then expect to find that [350 0.03125] 11 managers finish in the top half for each of the five consecutive
years.
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Problem 9
Trading costs will reduce the portfolio return by
(0.4%)x(0.50)= 0.2% Over many years of savings these costs can greatly
reduce the value of your portfolio.
Remember also that the high turnover rate can have tax consequences that further reduces your after-tax return.