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24Mutual FundOperations
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Chapter Objectives Explain the concept of mutual fund operation Explain various types of mutual funds Describe the various types of stock and bond
mutual funds Describe the characteristics of money market
funds
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Background on Mutual Funds Mutual funds offer a way for small investors to
diversify when they could not do so on their own with the purchases of individual stocks
Comparison to depository institutions Like depository institutions, mutual funds repackage
proceeds from individuals to make investments Bank deposits are a liability contract, but a mutual
fund represents partial ownership No federal insurance with mutual fund shares
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Background on Mutual Funds Mutual funds adhere to a variety of federal and
state regulations Securities and Exchange Commission (SEC) regulates Funds must register and provide a prospectus to
investors Disclosure since 1993 of manager’s name and length
of time employed in that position Mutual fund itself is exempt from income
taxation if fund distributes 90 percent of taxable income
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Background on Mutual Funds Mutual fund prospectus information includes:
The minimum amount of investment required The investment objective of the fund The return on the fund over the past year, the past three
years and the the past five years The exposure of the fund to various types of risk Services the fund offers
Check writing Telephone or Internet funds transfer
Management fees incurred that investors pay
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Background on Mutual Funds Estimating the net asset value
Net asset value is the value per share Estimated daily
Determine the market value of all the securities in the fund Any interest or dividends added in Expenses subtracted Divide by the number of shares Dividends lower NAV NAV quotes
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Mutual Fund Distributions
Mutual Fund Price Appreciation
Capital Gains from the Sale of Securities in Fund
Earned Income from Dividends or Coupon Payments
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Background on Mutual Funds Mutual fund classifications depend on the type
of securities the fund invests in and can include Stock or equity mutual funds Bond mutual funds Money market mutual funds
Family of funds offered by investment companies Investor able to allocate then transfer funds among
funds
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Exhibit 24.2 Distribution of Investment in Mutual Funds
Stock Funds$3,962 billion
57%
Bond Funds$808 billion
11%
Hybrid Funds$349 billion
5%
MoneyMarket Funds$1,845 billion
27%
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Background on Mutual Funds Management of mutual funds
Managers invest in a portfolio of securities to meet the objectives of the fund
Cover management costs with fees which are typically around one percent of total assets per year
Managers adjust the composition of their portfolios in response to market and economic conditions
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Background on Mutual Funds Expenses
Fees include management plus record-keeping and clerical fees
Expense ratio = annual expenses/fund NAV Passed on to investors since NAV is reduced by fees Investor should compare expense ratios
Active marketing expenses and compensation increases expenses—12b-1 expenses
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Background on Mutual Funds Corporate control by mutual funds
Mutual funds are large shareholders in companies whose stock they hold
Managers may serve on the board of directors of companies in which the fund invests
Companies try to satisfy mutual fund managers in order to keep them from selling their stake in the firm
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Load versus No-Load Mutual Funds Classification refers to whether or not there is a
sales charge No-load means funds are promoted, bought and
sold directly via the mutual fund Load funds
Promoted by registered representatives of brokerage firms who get a commission
Investors pay the sales charge 12b-1 expenses are “loads” used by no-load funds
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Open-End versus Closed-End Funds Closed-end funds
Mutual fund does not repurchase the shares they sell—similar to direct common stock investment
Investors must sell shares on an exchange Number of outstanding shares is constant Value of shares related to expectations of portfolio and determined
in market Open-end “mutual” funds
Willing to repurchase investor shares at any time Number of shares outstanding does not remain constant NAV determined by fund daily
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Stock Mutual Fund Categories Growth funds for investors who want high returns
with moderate risk Mutual fund invests in companies that are expected to
grow at a higher than average rate Generate an increase in investment value rather than
steady income Capital appreciation or aggressive growth funds
High but unproven growth potential stocks Higher risk
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Stock Mutual Fund Categories Growth and income funds try to offer growth
but with some stability of income International and global funds allow investment
in foreign securities without the costs involved in purchasing and monitoring individual stocks Returns affected by stock prices Returns also affected by foreign exchange rates
A global mutual fund invests in some U.S. stocks
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Stock Mutual Fund Categories Internet funds focus on investments in Internet
companies Specialty funds focus on a group of companies
sharing a particular characteristic Index funds are designed to simply match the
performance of an existing stock index Multifund funds invest in a portfolio of different
mutual funds More diversified Involves higher expenses
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Exhibit 24.3 Growth in Number of Equity and Bond Funds
Year
0
1000
2000
3000
4000
5000
6000
7000
8000
Bond Funds
S tock Funds
200119991995199019851978
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Exhibit 24.4 Investment in Bond and Stock Mutual Funds
Year
0
1000
2000
3000
4000
5000
Bond Funds
Stock F unds
2000199919981997199619951994199319921991199019891988198719861985
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Exhibit 24.5 Distribution of Aggregate Mutual Fund Assets
Common Stock$3,882 Billion
76%
Municipal Bond$269 Billion
5%Long-Term U.S. Gov’t
$309 Billion6%
Cash$277 Billion
5%
Corporate Bonds$349 Billion
7%
Preferred Stock$28 Billion
1%
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Bond Fund Investment Objectives Risks of bond funds
Interest rate risk Credit risk
Tax implications of bond fund investments Income bond funds vary in terms their exposure
to credit risk and focus on periodic coupon payments and attract investors who are Interested in periodic income since prices are volatile Plan to hold the fund long term
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Bond Fund Investment Objectives Tax-free funds for high tax bracket investors High-yield or junk bond funds invest in bonds
with a high risk of default International and global bond funds
International bond funds contain bonds issued by governments or corporations from other countries
Global funds may contain both U.S. and foreign bonds
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Bond Fund Investment Objectives Maturity classifications
Interest rate sensitivity depends on the maturity of bonds
Funds are typically segmented based on maturity Intermediate-term funds invest in bonds with 5 to 10
years remaining to maturity Long-term funds invest in maturities of 15 to 30 years
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Bond Fund Investment Objectives Asset allocation funds
Funds that contain a variety of investments Composition among stocks, bonds and money
market securities is based on manager’s expectations
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Growth and Size of Mutual Funds Volume and mix in the kind of funds varies
over time Overall investment via mutual funds much
higher in recent years New kinds of funds target customers with
different risk preferences
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Performance of Stock Mutual Funds Both investors and managers closely monitor
performance as modeled by the equation below
PERF = Performance
SECTOR = Conditions in the fund’s sector
Where:
PERF= f ( MKT, SECTOR, MANAB)
MKT = General stock market conditions
MANAB = The ability of the fund’s management
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Performance of Stock Mutual Funds Change in market conditions
Close relationship between performance and market conditions
Change in sector conditions Depends on the focus of the fund
Index funds Asian funds
Change in management ability includes both managers’ skills and operating efficiency
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Performance of Stock Mutual Funds Performance of closed-end stock funds
Driven by the same factors that influence open-ended funds
Fixed supply of the fund’s shares Additional issues
Performance is affected by changes in the premium or discount relative to NAV
If the fund’s premium increases relative to NAV, return to fund holders increases
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Performance of Bond Mutual Funds Performance of bond mutual funds as shown
in the model below PERF= f ( Rf, RP, CLASS, MANAB)
PERF = Performance
RP =Risk premium
Where:
Rf = Risk free interest rates
CLASS =the classification of the bond fund
MANAB = The ability of the bond fund’s management
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Performance of Bond Mutual Funds Change in the risk free rate
Bond prices are inversely related to the risk- free rate When rates decline, most bond funds perform well
Change in the risk premium If required risk premiums increase, bond prices fall Linked to economic condition:
Risk premiums increase in recessions Risk premiums decrease in boom times as investors buy
riskier investments
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Performance of Bond Mutual Funds Impact of the bond fund’s classification
Some funds target a specific risk or maturity Classification may have more impact than any
other factor Change in management abilities Performance of closed-end bond funds is
affected by all of the other factors and changes in the premium or discount
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Performance of Mutual Funds Investors should diversify among different kinds
of funds to reduce volatility Research on stock mutual fund performance
Using return only is not valid Mutual funds typically do not outperform the market Evaluate mutual fund expenses
Research on bond mutual funds Bond mutual funds underperform bond indexes Investors should look for low expense bond funds
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Money Market Funds Money market funds are portfolios of short-
term assets Can include check-writing privileges for investors Number of checks per month may be restricted Shareholders get periodic statements Liquid, “cash” balance for investor
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Money Market Funds Asset composition of money market funds
Individual funds concentrate in assets that reflect the fund’s objective
Money market securities of varying maturity Maturity of money market funds
Varies over time with market conditons Risk increases with term
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Exhibit 24.7 Composition of Money Market Fund Assets
U.S. TreasurySecurities$91 billion
6%
Other$303 billion
20%
Commercial Paper$620 billion
41%
CDs$123 billion
8%
RepurchaseAgreements$186 billion
12%
Other U.S. Securities$189 billion
13%
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Money Market Funds Risk of money market funds
Credit risk minimized by the short-term nature of maturities
Returns for money market funds fall as interest rates in the economy fall
Expected returns are low relative to stock and bond funds Consistent positive returns over time Lower credit risk Lower interest rate risk
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Money Market Funds Management of money market funds
Managers try to maintain the overall objective of the fund
Manage the composition of the assets Investors have a variety of choices when it comes
to money market funds
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Money Market Funds Regulation of money market funds
Securities Act of 1933 requires that funds provide full information to investors via a prospectus
Investment Company Act of 1940 contains restrictions to prevent conflicts of interest between investors and mangers
Funds are exempt from tax if 90% of earnings are distributed to shareholders
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Hedge Funds Financial problems experienced by Long-Term
Capital Management (LTCM) Hedge funds sell shares to wealthy investors and
financial institutions Historically unregulated Invest in derivatives, sell stock short, and combine
borrowing to magnify returns LTCM experienced problems when risky
investments lost money
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Real Estate Investment Trusts A real estate investment trust or REIT is a closed-end
mutual fund that invests in real estate or mortgages Classifications
Equity REIT Mortgage REIT Hybrid of the two
Sometimes seen as an inflation hedge Performance influenced by interest rates and area real
estate performance
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Other Issues Mutual funds interact with banks, savings
institutions, finance companies, securities firms, insurance companies, and pension funds
Mutual funds typically use all the various financial markets including money, bond, mortgage, stock, futures, options, and swap markets
Globalization is facilitated by mutual funds Reduces transactions costs Increases market integration