Mutual Funds Overview

1
Mutual Funds Overview

• Mutual funds are financial intermediaries that
  pool the financial resources of investors and
  invest those resources in diversified portfolios
  of assets
• Enjoy economies of scale by incurring lower
  transaction costs and commissions
• Shareholder services offered include free
  exchanges of investments between a companys
  funds, automatic investing, check-writing,
  automatic reinvestment of dividends, and
  automatic withdrawals
• As of January 2000, more than 7,800 mutual funds
  held total assets of 6.8 trillion

2
Historical Trends

• First mutual fund established in 1924
• Advent of money market mutual funds in 1972 as
  investors looked for ways to earn market rates on
  short-term funds
• Tax-exempt money market mutual funds introduced
  in 1979
• Special-purpose equity, bond, emerging market,
  and derivative funds exploded on the scene during
  the 1990s bull market

3
Growth of the Mutual Fund Market
4
Types of Mutual Funds

• Long Term
• Equity funds - funds consisting of common and
  preferred stock securities
• Bond funds - funds consisting of fixed-income
  capital market debt securities
• Hybrid funds - funds consisting of stock and bond
  securities
• Short Term
• Money market mutual funds - funds consisting of
  various mixtures of money market securities

5
Mutual Fund Prospectuses and Objectives

• Regulations require mutual fund managers to
  specify the investment objectives of their funds
  in a prospectus available to potential investors
• The prospectus includes a list of the securities
  that the fund holds and the investment objectives
  (i.e., aggressive growth funds, high-growth and
  high-risk securities)
• The SEC is proposing an initiative to require
  mutual funds to disclose more information about
  their return risk as well as the returns
  themselves to better enable investors to compare

6
Types of Mutual Funds

• Open-end mutual fund - a fund for which the
  supply of shares is not fixed but can increase or
  decrease daily with purchases and redemptions of
  shares
• Closed-end investment companies - investment
  companies that have a fixed supply of outstanding
  shares. Shares trade in the stock market
  throughout the trading day.
• Exchange Trade Fund (ETF) hybrid between
  open-end and closed-end funds. Shares trade
  throughout the day, but number of shares not
  fixed.
• REIT - a closed-end investment company that
  specializes in investing in mortgages, property,
  or real estate shares

7
Investor Returns from Mutual Fund Ownership

• The return for the investor reflects three
  aspects of the underlying portfolio of mutual
  fund assets
• portfolio earns income and dividends on those
  assets
• experiences capital gains sells an asset at a
  higher price
• capital appreciation in the underlying values of
  its existing assets adds to the value of mutual
  fund shares
• Marked to market - asset and balance sheet values
  adjusted to reflect current market prices
• NAV - the net asset value of a mutual fund --
  equal to the market value of the assets in the
  mutual fund portfolio divided by number of shares
  outstanding

8
Calculation of NAV

• NAV Total market value of assets under
  management
• Number of mutual fund shares
  outstanding
• Important Note For open end funds the NAV is
  calculated once per day based on prices as of 4
  pm in New York.
• Market Timing Rapid trading in and out of open
  end fund shares to take advantage of stale prices
  due to once a day calculation of NAV. Market
  timing is legal, but most funds claimed to
  discourage it.
• Late Trading Trading open end fund shares after
  the NAV has been calculated to take advantage of
  news released after the cutoff. Late trading is
  illegal.

9
Mutual Fund Costs

• Mutual funds charge shareholders a price or fee
• Two types of fees are incurred by investors
• Load versus No-load Funds
• Load fund - a mutual fund with an up-front sales
  or commission charge that the investor must pay
• No-load fund - a mutual fund that does not charge
  up-front sales or commission charges on the sale
  of mutual fund shares to investors
• Fund Operating Costs
• annual fees charged to cover all fund level
  expenses experienced as a percent of fund assets

10
Mutual Fund Costs

• Expense Ratio annual fee
• Management fee
• Operating expenses
• 12b-1 charge (sales charge)
• Sales Charges (Loads)
• Upfront load
• Deferred Withdrawal Fee (Contingent Deferred
  Sales Charge)
• 12b-1 charge (part of annual expense)
• Trading costs

11
Load vs No-Load Funds

• The SEC defines a no-load fund as
• No upfront load
• No deferred withdrawal fee
• 12b-1 charge no greater than 0.25
• Pure no-load fund
• No upfront load
• No deferred withdrawal fee
• No 12b-1 fee.

12
Mutual Fund Performance

• The average mutual fund does not beat the market.
  At best, they perform well enough to offset
  costs. Most studies find they dont even do that.
• While a few funds do better than the market, they
  are no more than could be expected from pure
  chance.
• Little evidence that winners repeat. However,
  some evidence that losers repeat.

13
Index Funds

• Mutual Funds that attempt to duplicate the
  performance of a market index
• Examples of indices
• SP 500
• Wilshire 5000 (total market)
• Bond market
• International stock market
• Advantages
• Low fees
• Above average performance

14
Exchange Trade Funds (ETFs)

• Mutual funds with shares that trade throughout
  trading day like closed end funds.
• Mechanisms designed to keep price close to NAV.
• Examples
• SPDRs
• QQQ Cubes (Nasdaq 100 Index)
• DIAMONDS
• iShares
• HOLDRs

15
Regulation

• This industry is heavily regulated to protect
  investors
• SEC is the primary regulator
• Securities Act of 1933 requires a mutual fund to
  file a registration statement with the SEC
• Securities Exchange Act of 1934 makes the
  purchase and sale of mutual fund shares subject
  to various antifraud provisions and appointed the
  National Association of Securities Dealers (NASD)
  to supervise
• Investment Advisers Act and Investment Company
  Act of 1940 established rules to prevent
  conflicts of interest, fraud, and excessive fees
  or charges
• Insider Trading and Securities Fraud Enforcement
  Act of 1988 requires mutual funds to develop
  mechanisms and procedures to avoid insider
  trading abuses