Chapter 23

Mutual Fund Operations

Financial Markets and Institutions, 7e, Jeff Madura Copyright 2006 by South-Western, a division of Thomson Learning. All rights reserved.

Chapter Outline
Background on mutual funds Stock mutual fund categories Bond fund categories Growth and size of mutual funds Performance of mutual funds Mutual fund scandals

Chapter Outline (contd)

Money market funds Hedge funds Real estate investment trusts Interaction with other financial institutions Use of financial markets Globalization through mutual funds

Background on Mutual Funds

Mutual funds:

Serve as a financial intermediary by pooling investments by individual investors and using the funds to accommodate financing needs by governments and corporations in the primary market Frequently invest in securities in the secondary market Provide an important service for individuals who wish to invest funds and diversify Offer liquidity if they are willing to repurchase an investors shares upon request Offer various different services, such as transfers between funds and check-writing privileges

Background on Mutual Funds (contd)

A mutual fund hires portfolio managers to invest in a portfolio of securities that satisfies the desires of investors

The portfolio composition is adjusted in response to changing economic conditions Monitors management Establishes procedures Ensures that the fund is properly serving its shareholders

The board of directors:

Under new SEC rules, a majority of board members must be outsiders

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Background on Mutual Funds (contd)

Types of funds
Open-end

funds:

Are open to investment from investors at any time Allow investors to purchase or redeem shares at any time Have a constantly changing number of shares Maintain some cash in case redemptions exceed investments Consist of many different categories to satisfy investors investment needs

Background on Mutual Funds (contd)

Types of funds (contd)

Closed-end

funds:

Do not repurchase shares they sell Require investors to sell the shares on a stock exchange Have a constant number of outstanding shares Have an asset size that is about 1/40th of the asset size of open-end funds Focus primarily on bonds and other debt securities

Background on Mutual Funds (contd)

Types of funds (contd)

Exchange-traded funds: Are designed to mimic particular stock indexes and are traded on a stock exchange Differ from open-end funds in that their shares are traded on an exchange, and their share price changes throughout the day Consist of a fixed number of shares Are not actively managed Have become very popular in recent years Typically do not have capital gains and losses that must be distributed to shareholders
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Background on Mutual Funds (contd)

Types of funds (contd)

Hedge funds: Sell shares to wealthy individuals and financial institutions and use the proceeds to invest in securities Differ from open-end funds because:

They require a much larger initial investment They may not always accept additional investments or accommodate redemption They are unregulated and provide very limited information to prospective investors They invest in a wide variety of investments to achieve high returns

Background on Mutual Funds (contd)

Comparison to depository institutions

Mutual funds repackage the proceeds from individuals to make various types of investments Investing in mutual funds represents partial ownership

Investors share the gains or losses generated by the fund

Regulation and taxation

Mutual funds must register with the SEC and provide a prospectus Mutual funds are regulated by state laws If a mutual fund distributes 90 percent or more of its taxable income to shareholders, it is exempt from taxes on dividends, interest, and capital gains
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Background on Mutual Funds (contd)

Information contained in a prospectus

The

minimum amount of investment required The investment objective The return on the fund over the past year, the past three years, and the past five years The exposure of the fund to various types of risk The services offered by the fund The fees incurred by the find that are passed on to investors

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Background on Mutual Funds (contd)

Estimating the net asset value

The

net asset value (NAV) of a mutual fund indicates the value per share
Estimated each day by determining the market value of all securities comprising the fund, adding interest or dividends, and subtracting expenses, then dividing by the number of shares outstanding

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Computing the NAV

Philly Mutual Fund has 50 million shares issued to its investors. It used the proceeds to buy stock in 100 different firms. These shares have a market value of $100 million. In addition, Philly incurred $7,000 in expenses today and collected interest and dividends totaling $5,000. What is the net asset value per share?
Net asset value Market value of fund/numbe r of shares ($100,000, 000 $5,000 - $7,000)/50 ,000,000 $99,998,00 0/50,000,0 00 $2.00
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Background on Mutual Funds (contd)

Distributions to shareholders
Mutual

funds generate returns to shareholders in three ways:

They pass on earned income as dividend payments They distribute capital gains resulting from the sale of securities within the fund Mutual fund share price appreciation

Mutual fund classifications

Stock

mutual funds, bond mutual funds, or money market mutual funds (see next slide)
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Background on Mutual Funds (contd)

Distribution of Investment in Mutual Funds

17% 6% 50%

Stock Funds Money Market Funds Hybrid Funds Bond Funds

27%
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Background on Mutual Funds (contd)

Expenses incurred by shareholders

Mutual

funds pass their expenses on to their shareholders Expenses can be compared among mutual funds by comparing the expense ratio

Equal to annual expenses per share divided by the NAV The higher the expense ratio, the lower the return for a given level of performance Mutual funds with lower expense ratios tend to outperform others with similar objectives

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Background on Mutual Funds (contd)

Expenses incurred by shareholders (contd)

Expenses

include:

Compensation to the portfolio managers and other employees Record-keeping and clerical fees Marketing fees 12b-1 fees cover advertising expenses or compensate brokerage firms that advised their clients to invest in that fund

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Background on Mutual Funds (contd)

Sales load
Load

funds have a sales charge

Promoted by brokerage firms who earn a sales charge between 3 and 8.5 percent Investors pay the sales charge through the difference between the bid and ask prices of the load fund Front-end load versus back-end load

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Background on Mutual Funds (contd)

Sales load (contd)

No-load

funds are promoted strictly by the mutual fund of concern

Preferred by investors who feel capable of making their own investment decisions Recently, some small no-load funds have become load funds because they could not attract sufficient investors

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Background on Mutual Funds (contd)

12b-1 fees:
Were

allowed in 1980 as distribution fees Have sometimes been used by funds to pay a commission to a broker whose clients invested in the fund May be charged instead or in addition to loads Are subject to much controversy because many funds do not specify how they use the money received
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Background on Mutual Funds (contd)

Corporate control by mutual funds

Large

mutual funds can exert control over the management of firms because they are commonly a firms largest shareholders

e.g., Fidelity is the largest shareholder of more than 700 firms

Portfolio

managers of many funds serve on the board of directors of various firms Many firms discuss any major policy changes with analysts and portfolio managers of funds to convince them that the change will have a favorable effect
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Stock Mutual Fund Categories

Growth funds are composed of stocks of maturing companies that are expected to grow at a high rate

The primary objective is to increase investment value

Capital appreciation funds are composed of stocks that have high growth potential but may be unproven

Suited to investors who are willing to risk a possible loss in value

Growth and income funds provide potential for capital appreciation with some stability in income

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Stock Mutual Fund Categories (contd)

International and global funds

International

funds invest in foreign securities Returns on international funds are affected by the foreign companies stock prices and the movements of the currencies that denominate the stocks Global funds include some U.S. stocks

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Stock Mutual Fund Categories (contd)

Specialty funds focus on a group of companies sharing a particular characteristic

e.g.,

energy or banking

Index funds are designed to match the performance of an existing stock index
e.g.,

Vanguard 500

Multifund funds invest in a portfolio of different mutual funds to achieve more diversification

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Bond Fund Categories

Income funds are composed of bonds that offer periodic coupon payments and vary in exposure to risk

Corporate bonds are subject to credit risk, Treasury bonds are not Bonds backed by government agencies are less risky than corporate bonds Allows investors in high tax-brackets to avoid taxes while maintaining a low degree of credit risk

Tax-free funds contain municipal bonds

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Bond Fund Categories (contd)

High-yield (junk) bond funds consist of at least twothirds of bonds rated below Baa by Moodys or BBB by S&P International and global bond funds

International funds contain bonds issued by corporations or governments based in other countries Global bond funds contain U.S. as well as foreign bonds Foreign bonds are subject to credit risk, interest rate risk, and exchange rate risk

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Bond Fund Categories (contd)

Maturity classifications

Bond funds are commonly segmented according to the maturities of the bonds they contain Intermediate-term bonds invest in bonds with 5 to 10 years remaining to maturity Long-term bond funds contain bonds with 15 to 30 years until maturity

Long-term bonds have more interest rate risk

Asset allocation funds contain a variety of investments such as stocks, bonds, and money market securities

Portfolio managers adjust the compositions of these funds in response to expectations

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Growth and Size of Mutual Funds

The number of stock and bond funds is substantially larger today than it was during the 1980s Growth funds, income funds, international and global funds, and long-term municipal bond funds are the most popular types of bonds (see next slide)

Growth and income funds are the most popular when measured according to total assets Common stocks are clearly the dominant asset maintained by mutual funds

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Growth and Size of Mutual Funds (contd)

Distribution of Aggregate Mutual Fund Assets

9% 5% 9% 6%
Liquid Assets Common and Preferred Stock Municipal Bond Treasury Bonds

71%

Corporate Bonds

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Performance of Mutual Funds

Performance of stock mutual funds

The

change in performance of an open-end mutual fund can be modeled as:

PERF f (MKT , SECTOR , MANAB )

Change in market conditions A mutual funds performance is closely related to market conditions The mutual funds beta can be used to measure the sensitivity of the funds exposure to market conditions

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Performance of Mutual Funds (contd)

Performance of stock mutual funds (contd)

Change in sector conditions The performance of a fund focused on a specific sector is influenced by market conditions in that sector In the late 1990s, many funds focused on technology stocks Change in management abilities Mutual funds in the same sector can have different performance levels because of differences in management abilities An efficient fund has low expenses and high returns

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Performance of Mutual Funds (contd)

Performance of closed-end stock funds

Generally

influenced by the same factors as open-

end funds The performance of closed-end stock funds is also affected by a change in the premium or discount

If a funds premium increases relative to its NAV, the return to shareholders is increased A strong demand for closed-end fund shares can push the market price of the shares above the NAV

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Performance of Mutual Funds (contd)

Performance of bond mutual funds

The

change in performance of an open-end mutual fund can be modeled as:

PERF f ( Rf , RP,CLASS, MANAB )

Change in the risk-free rate Bond prices are inversely related to changes in the risk-free interest rate Bond funds focused on longer maturities are more exposed to interest rate changes

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Performance of Mutual Funds (contd)

Performance of bond mutual funds (contd)

Change

in the risk premium

Bond prices decline in response to an increase in the risk premium Poor economic conditions tend to increase the risk premium

Change

in management abilities

The performance of specific bond classifications varies due to differences in managers abilities An efficient fund has low expenses and high returns

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Performance of Mutual Funds (contd)

Performance of closed-end bond funds

Driven by the same factors as open-end bond funds Closed-end bond funds are also affected by a change in their premium or discount The performance of any given mutual fund may be primarily driven by a single economic factor

Performance from diversifying among mutual funds

e.g., growth funds are highly dependent on the stock markets performance

Diversification across different mutual funds reduces susceptibility to any particular type of risk

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Performance of Mutual Funds (contd)

Research on stock mutual fund performance

The

performance should be compared to a market index and risk should be considered Most studies find that mutual funds do not outperform the market, especially when accounting for the type of securities that the fund invests in

Even when returns are adjusted for risk, mutual funds fail to outperform the market

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Performance of Mutual Funds (contd)

Research on bond mutual fund performance

In

general, bond funds underperform bond indexes Generally, bond mutual funds with higher expense ratios generate lower returns Past performance does generally not serve as a useful indicator for future performance

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Mutual Fund Scandals

In 2003, some funds were allowing their large clients to buy or sell the funds shares after the 4 p.m. closing but at the 4 p.m. prices

Late trading involves engaging in a trade on stale prices Violates 1968 SEC laws Investigated mutual funds once this problem was publicized Heavily fined some mutual funds Is attempting to restore investor confidence in mutual funds by prosecuting mutual fund managers

The SEC:

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Mutual Fund Scandals (contd)

Governance of mutual funds

The

investment company owners are different than the shareholders on the fund Some managers employed by mutual funds invest in the investment company rather than the mutual funds it manages

Incentive to charge high fees

Each

fund has a board of directors that is supposed to represent shareholders

The SEC requires that a majority of the director be independent
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Money Market Funds

Money market funds:

Are

portfolios of money market instruments constructed and managed by investment companies Allow investors to participate for as little as $1,000 Usually allow check-writing privileges Send periodic account statements to their shareholders Send shareholders periodic updates on any changes in the asset portfolio composition Sell some of their assets when redemptions exceed sales
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Money Market Funds (contd)

Asset composition of money market funds

Commercial

paper dominates, followed by Treasury and other U.S. securities (see next slide) During recessionary periods, the proportion of Treasury bills normally increases Each individual MMF is concentrated in whatever assets reflect its objectives

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Money Market Funds (contd)

Composition of Money Market Fund Assets in Aggregate

12% 27% 15%

Commercial Paper Other U.S. Securities U.S. Treasury Securities Other Repurchase Agreements CDs
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19% 8%

19%

Money Market Funds (contd)

Maturity of money market funds

The

average maturity is determined by individual asset maturities, weighted according to their relative value In the mid-1970s, the average maturity was relatively long By the late 1970s, average maturity had declined to less than half During the 1980s, the average maturity was about 40 days The average maturity has generally increased since the 1980s
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Money Market Funds (contd)

Risk of money market funds

Credit

risk is low, with the exception of commercial paper defaults Money market securities are not too sensitive to movements in market interest rates Expected returns on MMFs are low because of:

Low credit risk Low interest rate risk Consistently positive returns

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Money Market Funds (contd)

Management of money market funds

The

MMF portfolio manager maintains an asset portfolio that satisfies the underlying objective of the fund

Managers may change the asset composition if economic conditions change Managers may influence performance by changing the maturities of the securities in which they invest

Some

MMFs have little flexibility to change their portfolio composition because of their stated objectives
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Money Market Funds (contd)

Regulation and taxation of money market funds

The

Securities Act of 1933 requires sponsoring companies to provide full information on any MMFs they offer and a prospectus that describes the funds investment policies and objectives The Investment Company Act of 1940 contains numerous restrictions that prevent a conflict of interest by the funds managers If a fund distributes at least 90 percent of its income, the fund itself is exempt from federal taxation

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Hedge Funds

Sell shares to wealthy individuals and financial institutions and use the proceeds to invest in securities Have historically been unregulated but are not allowed to advertise Are usually organized as limited partnerships May allow investors to withdraw their investments but require advance notice of 30 days or more Often invest in derivative securities, sell short, or use borrowed funds along with equity investments Strive for high returns but also have a very high degree of risk

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Hedge Funds (contd)

Hedge fund fees

Management

fees usually range from 1 to 2 percent of the investment per year Incentive fees (usually 20 percent) are based on the return of the fund

Regulation
Hedge

funds are not regulated

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Real Estate Investment Trusts

A real estate investment trust (REIT):

Is

a closed-end mutual fund that invests in real estate or mortgages Allows small investors to participate with a low minimum investment Generates income by passing through rents on real estate or interest payments on mortgages Can typically be sold on a stock exchange Can be either classified as an equity REIT, a mortgage REIT, or a hybrid
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Interaction with Other Financial Institutions

Type of Financial Institution
Commercial banks and SIs

Interaction with Mutual Funds

MMFs invest in CDs at banks and SIs and in commercial paper issued by bank holding companies Some commercial banks have investment company subsidiaries that offer mutual funds Some stock and bond funds invest in securities issued by banks and SIs Some MMFs invest in commercial paper issued by finance companies Some stock and bond funds invest in stocks and bonds issued by finance companies Hire securities firms to execute security transactions for them Sometimes own a discount brokerage subsidiary that competes with other securities firms

Finance companies

Securities firms

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Interaction with Other Financial Institutions (contd)

Type of Financial Institution
Insurance companies

Interaction with Mutual Funds

Some stock funds invest in stocks issued by insurance companies Some insurance companies have investment company subsidiaries that offer mutual funds Some insurance companies invest in mutual funds Pension fund portfolio managers invest in mutual funds

Pension funds

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Use of Financial Markets

Type of Financial Market
Money markets Bond markets

How Mutual Funds Use That Market

MMFs invest in various money market instruments Some bond funds invest mostly in bonds issued by the Treasury or government agencies; others invest in bonds issued by municipalities or firms Foreign bonds are sometimes included in a bond mutual fund Some bond funds invest in bonds issued by Ginnie Mae, which uses the proceeds to purchase mortgages that were originated by some financial institutions Stock funds include stocks with various degrees of risk and potential return Some bond funds periodically attempt to hedge against interest rate risk by taking positions in interest rate futures Some stock funds hedge specific stocks by taking positions in stock options Some funds take positions in stock options for speculative purposes Some bond funds engage in interest rate swap to hedge interest rate52 risk

Mortgage markets

Stock markets Futures markets Options markets Swap markets

Globalization through Mutual Funds

International and global mutual funds have facilitated international capital flows and helped create a global securities market

Can reduce excessive transaction costs Increase the degree of integration among stock markets

European countries have recently agreed to allow their respective mutual fund shares to be sold across their borders Due to NAFTA, qualified companies are allowed to sell mutual fund shares in Mexico
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