1 Mutual Funds Definition: Financial intermediary through which savers pool their monies for...

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Mutual Funds

•Definition: Financial intermediary through which savers pool their monies for collective investment, primarily in publicly trades securities.

•A fund is “mutual” in the sense that all of its returns minus its expenses, are shared by its shareholders.

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Mutual Funds

•Returns consist of dividends, realized and unrealized capital gains (losses)

•Expenses consist of advisory fee for servicing the shareholders, annual fee for distribution (12b-1)

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Mutual Funds Vs. Individual Securities

• Objective is to maximize return with minimum risk

• Efficient Market hypothesis and undervalued securities

• Mean reversion in the equity market

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Mutual Funds Vs. Individual Securities

•Individual securities have two main sources of risk: alpha and beta.

•Alpha - company specific risk usually accounts for 50%-70% of security’s price volatility;

•Beta - market risk accounts for 30%-50% of price volatility.

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Bond Funds Vs. Individual Bonds

• Investors are focused on income stream

• To receive income, investors can buy individual bonds - T-bonds, agency bonds, corp. bonds, municipal bonds, and hold to their maturity. Receive periodic fixed interest payment and principal at maturity.

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•Alternatively, receive income stream by buying a diversified bond mutual fund. No fixed interest payment nor an obligation to pay principal at maturity.

• Higher minimum requirements for individual bonds (usually $25,000; T-bonds $1,000). Lot size is usually $100,000. One $25,000 bond lacks diversification.

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•Cost : 2% - 4% of value.

•Bond mutual fund minimum: As low as $1,000. Can redeem fund on any business day. Do not have to hold till maturity.

•Fund offers more diversification. Offer convenient services, such as monthly income payments, compared to quarterly or semi-annually for individual bonds

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Benefits of Investing in Mutual Funds

• Diversification :Typically lowers ; global fund may also lower • Professional Management: Professional qualifications (CFA); access to company executives; in house research team, wall street research.

• Lower Transaction Costs: Lower admn. cost, savings on record keeping, better execution of securities.

• Convenience: Automatic deposits/ withdrawal, tax reporting, retirement planning, educational materials.

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Disadvantages of Investing in Mutual Funds

•Need to pay fees/expenses even when fund performs poorly

•Increased diversification may prevent the chance of “hitting the jackpot” from one security

•Online trading and security research on the internet have reduced the advantage of cost and research access

•Less control over securities portfolio and therefore timing of realized capital gains for tax purposes.

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What Investors Need to Know?

•Structure and working of a typical fund

•Roles of various entities involved in operating a fund.

•Fund Manager, Custodian, distributor, etc.

•Minimum investment requirement

•Fees and Expenses

•Services provided to the shareholders

•Performance measurements

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Investment Objectives and Risks of Stock and Bond Funds

•Investor must clearly evaluate his/her own goals.

•What is the purpose of the investment?

•What is the time horizon?

•What is your risk tolerance?

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Mutual Fund Investment Objectives

• A fund’s objective is established when the fund is created. Objective can be changed with a majority vote of the shareholders.

• A fund’s objective denotes the type of assets a fund manger will buy or sell; such as:

• primary method by which the manager seeks to generate value for shareholders (capital appreciation, dividend payment, interest income, etc.)

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• the class or classes of assets (stocks, bonds, money market securities) and types of securities (growth stoc, income stock, municipal bonds, corporate bonds, etc.)

• Reasons for proliferation of fund objectives:

• Competition - sponsors imitating successful funds by competitors;

• Shareholder retention - sponsors profit from higher

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retention of shareholders. Greater variety of objectives offer the likelihood of customers staying within the same fund family;

• Refinement of investment objective - ‘splicing’ allows investor with a specific risk tolerance and time horizon to invest in appropriate fund.

• Greater variety allows investors a broader arena for optimizing returns, but makes selecting a fund that is suitable to investment goal more complex.

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Types of Mutual Funds

T a x E xem pt

T a xa b le

M o n e y m a rke t E q u ity

T a x E xam pt

T a xa b le

B ond H yb rid(S to ck & B o n d)

B ond

E q u ity

In dex F u nd o f Fu nd

T yp es o f Fu n ds

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Types of Mutual Funds (Money Market)

• MONEY MARKET FUNDS: Invests in high quality, low risk, short-term debt securities (T-bills, banker’s acceptance, negotiable CD’s, etc.).

•Low risk of default and high liquidity. Managers are limited to buying short-term securities rated investment grade by Moody’s and S&P.

•Attempts to maintain NAV of the fund at $1 per share; achieve this by purchasing debt securities that are trading at a discount to their face value.

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• Interest accrues daily

• Money market funds are neither insured nor guaranteed by the U.S. Government. Funds are not insured by the FDIC.

• Like other securities, MMF are insured by Securities Investor Protection Corporation (SIPC). SIPC is a government sponsored private corporation that provides limited protection (up to $100,000) for customer if their broker/dealer goes bankrupt.

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• Five Basic Types Of Money Market Funds:

1.GOV’T SECURITIES MONEY MARKET FUNDS

• Invests in T-bills, T-notes, and agency securities;

• 90 days or less to maturity;

• Income earned is subject to federal income tax but may be exempt from state and local taxes;

•Considered to be the safest type of MMF.

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2. U.S. TREASURY MONEY MARKET FUND

• Invests only in U.S. government securities issued directly by the U.S. Treasury with short term maturity;

•Agency securities are not included;

• Income earned is subject to federal taxes, but exempt from state and local taxes.

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3. TAXABLE MONEY MARKET FUND

• Invests in bank obligations such as, negotiable CDs, short-term debt obligations traded between institutions. Agency securities are not included;

• Income earned is subject to federal , state and local taxes.

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Types of Mutual Funds (Tax Exempt Money Market)

4. NATIONAL TAX EXEMPT MONEY MARKET FUND

• 75% of its assets is invested in high quality debt securities issued by municipality.

• 90 days or less to maturity;

• Income earned is exempt from federal income taxes, but is subject to state and local taxes;

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Types of Mutual Funds (Tax Exempt Money Market)

5 SINGLE STAT, DOUBLE TAX EXEMPT MONEY MARKET FUND

• Invests in municipal securities issued by a single state;

•Income earned is exempt from federal and state taxes, but may be subject to local taxes.

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Types of Mutual Funds (Equity Funds)

• EQUITY FUNDS invest primarily in common stocks

• Returns are generated through capital gains and dividend yields

•Portfolio manager selects stocks whose profile matches the fund’s investment objective

• Stocks are categorized based on features, such as dividend history, potential for capital gains, asset size, cyclical nature of the stock, etc.

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Types of Mutual Funds (Categories of Common Stocks)

• Basic Categories of Common Stocks:

•Blue Chip - large and most successful public companies (IBM, GE, DuPont, …); ability to maintain and grow profits, as well as increase dividends over a long period time through different market conditions.

• Establish Growth - large in asset size; stocks traded over several years; steady increase in sales and earnings and therefore stock price; most pay

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Types of Mutual Funds (Categories of Common Stocks)

little or no dividends (Microsoft; Coca-Cola, McDonald’s, …).

• Returns are generated from price increase; price volatility is greater than Blue Chips.

• Income Stocks - pay a higher percentage of earnings as dividends (utility companies); investors adhere to “buy-hold” philosophy; less volatile than the market.

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Types of Mutual Funds (Categories of Common Stocks)•Emerging Growth Stocks - little or no track record of steady growth of sales and earnings; growth and earnings potentials have recently been recognized investors (e-commerce, internet, biotech,…); pay no dividends; have commercially viable product; if successful, considerable fortune to be made.

• Defensive Stocks - share prices are less adversely affected during declines in the economy, yet offers a reasonable rate of return when the economy is doing well.

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Types of Mutual Funds (Categories of Common Stocks)• Capitalization: Current value of a publicly traded company ( #shares at current market price)

• Large Cap: current market value of $5 billion or more;

• Mid-Cap: current market value of between $1 billion to $5 billion;

• Small-Cap: current market value of between $300 million to $1 billion;

•Micro-Cap: current market value of $300 million or less.

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Equity Fund Objectives

A g g ress iveG ro w th

C a p ita lA p pre c ia tion

E q u ityIn com e

G ro w th G ro w tha n d Incom e

In te rn a tion a l/F o re ign

S e c to r/S p e c ia lty

S m a llC o m ap a ny

W o rld /G lo b a l

E q u it F un d O b je ctives

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Types of Mutual Funds (Equity Fund Objectives)

• AGGRESSIVE GROWTH: invest in stocks whose market prices are expected to rise rapidly; also invests in a single sector or industry; employs speculative investment strategies, such as margin and selling short; primary portfolio holdings in:

• Emerging growth stocks;• mid cap stocks;• small cap stocks.• IPO

•Tend to provide high gains during rally and steep drops during market declines; high volatility.

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• CAPITAL APPRECIATION: speculative in nature; invest in stocks whose prices are expected to rise; price increase may be due to increase in earnings expectation or purely demand/supply led.

• Investment horizon may be short-term or long-term; relatively high turnover and therefore higher transaction costs.

• Employ speculative investment strategies, such as margin and options; may also maintain large cash holding.

• High price volatility.

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• EQUIY INCOME: primary objective is to provide current income.

• Portfolio consists of large cap, blue chip and defensive stocks that pay large dividends.

• Volatility moves in tandem with or lower than overall market.

• Low shareholder turnover during a downturn; high dividend makes the yield higher as the share price declines.

• If stocks starts to pay low dividends, less incentive to hold on to the fund.

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• GROWTH: primary objective is capital appreciation; dividend payments are decidedly a secondary objective.

• Portfolio consists primarily of large cap and mid cap growth stocks; may also contain a small percentage of emerging growth and small cap growth if the manager recognizes significant potential for growth.

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•Volatility among growth funds varies widely:

• Type of stock that the fund manager considers as a growth stock- Coca-Cola vs. Amazon.com. Both considered growth stock, but varied risk.

• Investment Style: more speculative ( profiting from short-term gains) style leads to more volatility;

• Important to read the fund prospectus carefully to determine the nature of risk involved.

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• GROWTH AND INCOME: capital appreciation and current income are equally important.

• Portfolio consists of large cap, income and established-growth stocks; stocks must have potential for growth and ability to pay steady and increasing dividends.

• The blend of growth and income stock creates a portfolio volatility that is less than the overall market.

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• INTERNATIONAL OR FOREIGN: primary objective is capital appreciation from commons stock companies located outside the US; dividend payments are not usually a consideration.

•Foreign funds are ‘spliced’ in different ways:

•Country/Region•Diversified Emerging market•Europe Fund•Pacific Fund•Latin America Fund

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•WHY INVEST IN FOREIGN STOCKS:

•Foreign stocks constitute a greater percentage of the value of the world’s stock market than do US stocks;

•Many foreign economies are in the early stages of development - opportunity for significant capital gains;

•Portfolio Diversification - not all foreign markets move in tandem with the US market.

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• Risk of foreign funds varies depending on the type of fund and the period of investment. Expose to currency risk.

•Asset allocation models recommend 5 to 20 percent holding of foreign funds.

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• GLOBAL FUND: invests in equity securities issued throughout the world; maintains 25% - 50% of assets in US companies.

• Safe way to invest in international markets:

• US multinationals pay dividends in dollars - investors are shielded form currency risk;

• US multinationals’ shares are traded on the US stock markets; performance closely follows the US market performance and not the foreign markets.

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• Fund Volatility: volatility depends on the mixture of foreign and US equities. As high as 75% of assets can be held in foreign equities. Depending on the mixture, the fund volatility may track or move opposite to the US markets.

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• SECTOR FUND: primary objective is capital appreciation.

• Portfolio consists of stocks of companies of a single industry/sector/geographical region.

• RISK is high - specialized concentration can produce

spectacular returns and losses. Example: investment in

Telecom or Internet sectors in 1999-2000 vs. 2001-03.

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• Popular Sector Funds:

• Communications• Financial Services• Health Care• Natural Resources• Precious Metals• Real Estate• Technology• Utilities

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Types of Mutual Funds (Bond Fund Objectives)

• BOND FUNDS: considered to be safer than stock funds. Attracts conservative investors with low risk tolerance.

• Historically, returns are less than stock funds. Principal source of return is interest payments with limited potential for capital gains.

• Market price of bonds do not increase as company’s sales and earnings grow; bond prices are inversely related to interest rates.

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Types of Bond Funds

H ig h Y ie ld(Ju n k B o n d s)

H ig h Q u a lity

G e ne ra l

C o rpo rta teB o nd Fu nd

U .S .T re a su ry

M o rtga g e-B a cked

S e cu rit ies

G e ne ra l

A d ju sta b leR a te M orta ge

G o ve rn m e ntB o nd Fu nd

In te rn a tio n a lB o nd Fu nd

M u lt i-S e c to r B on d Fu nd

W o rldB o nd Fu nd

T a xab le B o nd Fu n ds

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Types of Bond Funds

N a tion a l Ta x E xe m ptB o nd Fu nd

S in g le S ta te T a x-E xem pt B o nd Fu nd

T a x E xem ptB o nd F un ds

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• BOND FUND objectives are defined using criteria such as:

• Types of bonds - corporate, government, yankee (dollar denominated, issued in the US by foreign corp. or gov’t), euro (dollar denominated, issued outside the US), etc.

• Bond rating• Average length of maturity• Taxation of interest income from bonds - taxable or tax exempt fund.

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• BOND FUNDS: considered to be safer than stock funds. Attracts conservative investors with low risk tolerance.

• Historically, returns are less than stock funds. Principal source of return is interest payments with limited potential for capital gains.

• Market price of bonds do not increase as company’s sales and earnings grow; bond prices are inversely related to interest rates.

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Types of Mutual Funds (Taxable Bond Fund Objectives)

• CORPORATE BOND FUNDS: invest primarily in US issued corporate bonds, but may invest in debt securities issued by foreign corporations. Fixed income securities include:

• Debentures : unsecured bonds;

• Mortgage bonds : secured by real estate and property

•Equipment Truest Certificates (ETC): secured by the equipment of the issuers. Airlines use ETCs extensively.

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• CORPORATE BOND FUNDS are further categorized as:

•General Corp Bond Fund: buys only investment grade bonds of US based corp. (Aaa -Baa/AAA-BBB);

• High Quality Corporate Bond Fund: majority of assets are invested in bonds rated A or better; manager tries to maintain a rating of Aa or AA among all bonds;

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• High Yield Corporate Bond Fund: majority of assets are invested in bonds rated BB of Ba, or lower.

• Interest income from these securities are taxable at the federal, state and local levels.

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Types of Mutual Funds (Gov’t Bond Fund Objectives)

• GOVERNMENT BOND FUNDS: invest in long-term debt securities issued by the US gov’t or by its agencies (GNMA, SLMA). Agency securities are not backed by the gov’t but the agency itself. Agency securities are as safe as the US gov’t issues.

• Interest income from US gov’t bonds are subject to federal taxes, but are exempt from state and local taxes.

• Taxation of agency issues vary - Mortgage backed securities are fully taxed; all other issues are taxed as gov’t issues.

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• TYPES OF GOVERNMENT BOND FUNDS include:

• Adjustable Rate Mortgage fund: majority of assets are invested in mortgage backed securities (GNMA, FNMA, FHLMC) secured by pool of adjustable rate mortgages.

• General Government Bond Fund: invests in T-notes, T-bonds, STRIPS, TIPS, mortgage backed securities and other US government and agency securities.

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• US Treasury Government Bond Fund: all assets are invested in bonds and notes issued by the US government. One of the safest mutual funds available.

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• INTERNATIONAL BOND FUNDS: invest largely in debt securities issued by foreign corporations or governments; denominated in foreign currencies; attempts to earn income from interest payments and capital gains.

• Foreign securities are substantially more volatile than domestic debt; exposed to currency risk.

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• MULTI-SECTOR BOND FUNDS: invest in long-term debt securities including government bonds, corporate bonds, foreign bonds, and eurobonds. It may also invest in high-yield (junk) bond issued by US based corporations.

• WORLD BOND FUNDS: invest in long-tern debt securities around the globe; large percentage of assets are invested in sovereign debt. Interest payments, and to a lesser extent, capital gains are the main sources of income.

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Types of Mutual Funds (Tax Exempt Bond Fund Objectives)

• NATIONAL TAX EXEMPT BOND FUND ( known as National Municipal Bond Fund): invests in long-term municipal debt securities of town, cities, states and municipalities in the US.

• Income consist primarily of interest payments; interest is exempt from federal taxes; subject to state and local taxes.

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Types of Mutual Funds (Tax Exempt Bond Fund Objectives)

• SINGLE STATE TAX EXEMPT BOND FUND: consists of debt securities issued by and within one state. New York and California, because of the size of their bond issues are used most frequently.

• Interests are double tax exempt - exempt from federal and state taxes for resident of the single state. May also be triple tax exempt depending on the tax code of the local municipality.

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Redeeming Fund Shares• For front end load funds, especially with no

contingent deferred charges, fund simply buys back

shares at the NAV and distributes the proceeds.

• For back end load funds, all charges are deducted from

the proceed. The amount of deduction is based on the

number of shares sold. The percentage deduction is

calculated by the lesser of :• a) the original purchase price of the shares, or• b) the NAV at the time of redemption.

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Redeeming Fund SharesExample of Redeeming a back end load fund:

•1000 shares purchased 3 years ago at NAV of $13.0;

back end load begins at 5% and declines by 1% each

year to 0%; current NAV $20.20; want to sell 50

shares; what is the back end load?

• Total proceed ($20.20x50) = $1,010

• Load based on original purchase price = 3%x$13x50= $19.50

• Net Proceed = ($1,010 - 19.5) = $990.50.

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Redeeming Fund SharesLoad based on NAV at the time of redemption =

3%x$20.20x50= $30.30

• Net Proceed = ($1,010 - 30.30) = $979.70.

• Therefore, use original purchase price basis.

• If current NAV = $12.0• Load = 3%x$12.0x50 = $18.0

•Use current NAV method.

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Deciding Which Shares to Redeem

• Redeeming fund’s share has tax implications;

• If redemption results in capital gains, pay tax during the year when the transaction occurred;

• capital loss can be used to offset gains on another security.

• Tax planning is an important part of redemption;

• Decide which share of your holding will be sold, because it will determine:

• Cost basis of current sale; and• Tax on current sale.

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Redeeming Fund Shares• Three methods of selecting the shares for redemption:

• First In. First Out. Shares purchased first will be redeemed first.

• Average Cost: The fund computes the average purchase price of the shares being sold; becomes the cost basis.

• Specific Shares: Specify broker specific shares you want to sell according to their cost basis

• Once a method is decided, it must be followed.

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Redeeming Fund SharesExample of Redeeming a back end load fund:

•1000 shares purchased 3 years ago at NAV of $13.0;

back end load begins at 5% and declines by 1% each

year to 0%; current NAV $20.20; want to sell 50

shares; what is the back end load?

• Total proceed ($20.20x50) = $1,010

• Load based on original purchase price = 3%x$13x50= $19.50

• Net Proceed = ($1,010 - 19.5) = $990.50.

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