Mutual Funds

1
Mutual Funds

• Finance 7320
• Lecture 4

2
Investment Companies

• Financial intermediaries which pool funds to buy
  assets
• Advantages
• Record keeping and administration
• Diversification
• Professional management
• Lower transaction costs
• Net asset value

3
Types of Investment Companies

• Unit investment trusts
• Portfolio fixed for life of fund
• Unmanaged
• Most fixed income securities (tax exempt)
• Managed investment companies
• Closed-end funds
• Do not redeem or issue shares Fixed
• Shares traded on exchanges
• Usually sell at discount to NAV

4
Types of Investment Companies

• Open-end funds (mutual funds)
• Redeem or issue shares at NAV
• Number of shares O/S varies
• Many carry a load or sales charge
• Real estate investment trust (REIT)
• Similar to closed-end fund
• Invests in real estate directly
• Or, invests in mortgage construction loans
• Income usually passed through to investor

5
Mutual Fund Types

• Money market funds
• Equity funds
• Maximum capital gain
• Growth
• Growth income
• Income
• Income security
• Fixed income
• Balanced funds
• Asset allocation funds
• Index funds
• Specialized sector funds

6
Mutual Fund Costs

• Front-end load - sales charge on purchase
• Back-end load - exit fee, usually declining
• Operating expenses - admin. Advisory
• Usually .2 to 2
• Reduce value of portfolio
• 12b-1 charges
• Marketing costs and commissions
• Paid annually Like operating expenses

7
Mutual Fund Returns

• Reflect operating expenses 12b-1 fees
• Do not reflect loads
• R (NAV1 - NAV0 inc/gain Distrib) NAV0
• Expenses reduce NAV
• Investor has to be careful
• Taxes
• Income/gains passed through
• Function of turnover

8
Cost Return Example
9
Performance

• Risk differs significantly MM v. Equity
• Need a benchmark ex Wilshire 5000
• 1970 - 1997
• Wilshire 5000 12.97 annual
• Average fund 11.87 annual
• Reduce by .30 to reflect expenses
• Funds which repeat performance

10
Problem 16

• Mutual fund 4 load .5 expense ratio
• CD 6 interest
• A. If invest for two years, what must rate be on
  mutual fund to be better off than CD?
• (1x.96)x(1 R - .005)2 gt (1 6)2
• .96 x (1 r - .005)2 gt 1.1236
• (1 r - .005)2 gt 1.1704
• 1 r - .005 gt 1.0819
• R gt 8.69

11
Problem 16

• Mutual fund 4 load .5 expense ratio
• CD 6 interest
• B. What if you invest for 6 years?
• (1x.96)x(1 R - .005)6 gt (1 6)6
• .96 x (1 r - .005)6 gt 1.4185
• (1 r - .005)6 gt 1.4776
• 1 r - .005 gt 1.0672
• R gt 7.22
• Spreading fixed cost load over more years.

12
Problem 16

• Mutual fund 4 load .5 expense ratio
• CD 6 interest
• C. What if fund assesses 12b-1 fee of .75?
• 1 r - .005 - .0075 gt 1.06
• R gt 7.25 regardless of time horizon