Chapter 4

MUTUAL FUNDS AND OTHER

MANAGED INVESTMENTS

Mutual Fund Growth

Mutual funds have
become very
popular investment
vehicles.
Nearly $7.5 trillion in
total assets in 2004.
Total assets have
grown 600% since
1990.

What is a mutual fund?

Mutual funds are open-end investment
companies.
The fund sells shares to the public and
invests the proceeds in a pool of funds,
which are jointly owned by the funds
investors.

Computing Net Asset Value

For investors, the performance of their
investment depends on what happens
to the funds per share value, or net
asset value (NAV).
NAV= Market Value of Assets Liabilities
Number of Shares Outstanding

Why invest with mutual

funds?
Liquidity
Funds buy and sell their own shares quickly, even
if fund investments are illiquid

Diversification
Small minimum investment buys a typically welldiversified investment

Professional management and recordkeeping

Expertise and services

Why invest with mutual

funds?
Choice and flexibility
Families of funds offer a variety of
investments to match investor needs

Indexing
Some funds track a broad market index
which insures that investors will earn the
market return
Increasingly popular mutual fund
alternative

Mutual Fund Drawbacks

Active trading contributes to high costs
which lower fund returns (Turnover)
Tax consequences can be a
disadvantage
Tax impacts of asset trading are passed
through to investors
Tax bill can be large even when the NAV
falls

Mutual Fund Returns

Three sources of return:
Income distributions (ID)
Bond interest, stock dividends

Capital gain distributions (CGD)

Realized gains/losses from selling assets

Changes in NAV (DNAV)

From unrealized gains/losses from assets

Types of Mutual Funds

Funds can be classified according to
the type of security in which they invest
Stock Funds
Municipal Bond Funds
Stock and Bond Funds
Money Market Funds

Common Stock Funds

Most popular type of fund
Wide variety with different objectives
and levels of risk
Growth
Industry or sector funds
Geographic areas
International or Global
Equity Index funds

Municipal Bond Funds

Provide investors with income exempt
from Federal taxation
Often concentrate on single states to
avoid state income taxation as well

Stock and Bond Funds

Seek to provide a combination of
income and value appreciation.
Different names
Balanced funds
Blended funds
Flexible funds

Money Market Funds

Provide safe, current income with high
liquidity
Invest in money market securities
T-bills, Bank CDs, Commercial paper, etc.

NAV stays at $1; income either paid out

or reinvested daily
Provide an alternative to bank deposits,
but not FDIC insured

Mutual Fund Prospectus

Must be available to investors and should be
review by investors.
Contains:

Funds investment objective

Investment strategy
Principal risks faced by investors
Recent investment performance
Expenses and fees
Lots of other detailed information

Mutual Fund Expenses and

Considerations
Loads
Commission to the broker to financial advisor who
sold the fund to the investor
For load funds, the offer price is the funds NAV
less the load (while no-load funds are sold at their
NAV)
Load range from around 3% (low-load) to 8.5%

Fees
Fees deducted from the asset value of the fund to
cover marketing expenses
An alternative to loads

Mutual Fund Expenses and

Considerations
Management Fees
Fees deducted from the funds asset value
to compensate the fund managers
Some adjust fees according to the funds
performance

Expense ratio
Adding all fees and calculating expenses
as a percentage of the funds asset

Mutual Fund Return and Risk

Performance
Return Performance
On a risk-adjusted basis, portfolio managers
seem to out-perform the market before
expenses, but net returns are below the
market index
Some above-average performers over short
time horizons, but such performance is not
generally sustained (just luck?)
These results help to explain the growing
popularity of index funds

When should you sell a

mutual fund?
Personal considerations
Portfolio rebalancing points due to life cycle
considerations

Fund considerations

Change in portfolio manager

Change in investment style
Fund is growing too large or too fast
Persistent bad performance

Other Managed Investments

Closed-end investment companies
Shares trade like stock rather than
being bought and sold from the fund
Number of shares are fixed
Often sell at a discount from NAV (a
puzzle for modern finance)
Often a means of investing in a pool of
assets from a foreign country

Other Managed Investments

Exchange-traded funds (ETFs)
Relatively new, yet very popular
Like closed-end funds, they trade like
individual stocks
Passively managed to mirror a market index,
both broad and narrow
Low expenses, but do involve brokerage
commissions
Tax and liquidity concerns