2–1

Measurement of Mutual Funds

• By Total ReturnIncome + Capital Gain +/- Price Change

Initial Investment

• Versus Return of Peer Groups– By broad or narrow categories of fund investments

– By investment objective

– By investment style based on historical holdings (general equity funds)

• Versus Return of an Index– May be broad or focus on particular region or country

– “Theoretical” index return does not include expenses that would be involved if an actual portfolio

2–2

Types of Mutual Funds

T a x E xem pt

T a xa b le

M o n e y m a rke t E q u ity

T a x E xam pt

T a xa b le

B ond H yb rid(S to ck & B o n d)

B ond

E q u ity

In dex F u nd o f Fu nd

T yp es o f Fu n ds

2–3

Distribution of Mutual Funds by Assets, July 2007

Stock funds57%Money

market funds23%

Hybrid funds6%

Bond funds14%

Source: Investment Company Institute (ICI)

2–4

Money Market Fund

• MONEY MARKET FUNDS: Invests in high quality, low risk, short-term debt securities (T-bills, banker’s acceptance, negotiable CD’s, etc.).

•Low risk of default and high liquidity. Managers are limited to buying short-term securities rated investment grade by Moody’s and S&P.

•Attempts to maintain NAV of the fund at $1 per share; achieve this by purchasing debt securities that are trading at a discount to their face value.

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Money Market Fund

• Interest accrues daily

• Money market funds are neither insured nor guaranteed by the U.S. Government. Funds are not insured by the FDIC.

• Like other securities, MMF are insured by Securities Investor Protection Corporation (SIPC). SIPC is a government sponsored private corporation that provides limited protection (up to $100,000) for customer if their broker/dealer goes bankrupt.

2–6

Money Market Fund

• Five Basic Types Of Money Market Funds:

1.GOV’T SECURITIES MONEY MARKET FUNDS

• Invests in T-bills, T-notes, and agency securities;

• 90 days or less to maturity;

• Income earned is subject to federal income tax but may be exempt from state and local taxes;

•Considered to be the safest type of MMF.

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Money Market Fund

2. U.S. TREASURY MONEY MARKET FUND

• Invests only in U.S. government securities issued directly by the U.S. Treasury with short term maturity;

•Agency securities are not included;

• Income earned is subject to federal taxes, but exempt from state and local taxes.

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Money Market Fund

3. TAXABLE MONEY MARKET FUND

• Invests in bank obligations such as, negotiable CDs, short-term debt obligations traded between institutions. Agency securities are not included;

• Income earned is subject to federal , state and local taxes.

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Money Market Fund

4. NATIONAL TAX EXEMPT MONEY MARKET FUND

• 75% of its assets is invested in high quality debt securities issued by municipality.

• 90 days or less to maturity;

• Income earned is exempt from federal income taxes, but is subject to state and local taxes;

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Money Market Fund

5. SINGLE STAT, DOUBLE TAX EXEMPT MONEY MARKET FUND

• Invests in municipal securities issued by a single state;

•Income earned is exempt from federal and state taxes, but may be subject to local taxes.

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Bond Funds

• Definition: Bond funds invest primarily in debt securities with maturities of different lengths (generally >1 year)

• Taxable bond funds– U.S. Treasury or government agency– High-grade corporate– High-yield (sometimes called “junk”)– Asset-backed– Global or foreign

• Tax-free bond funds– National municipal– State municipal

2–12

Types of Bond Funds

H ig h Y ie ld(Ju n k B o n d s)

H ig h Q u a lity

G e ne ra l

C o rpo rta teB o nd Fu nd

U .S .T re a su ry

M o rtga g e-B a cked

S e cu rit ies

G e ne ra l

A d ju sta b leR a te M orta ge

G o ve rn m e ntB o nd Fu nd

In te rn a tio n a lB o nd Fu nd

M u lt i-S e c to r B on d Fu nd

W o rldB o nd Fu nd

T a xab le B o nd Fu n ds

2–13

Types of Bond Funds

N a tion a l Ta x E xe m ptB o nd Fu nd

S in g le S ta te T a x-E xem pt B o nd Fu nd

T a x E xem ptB o nd F un ds

2–14

Stock Funds

• Definition: Stock funds invest primarily in equities (common and preferred stock)

• Domestic (U.S.) funds– From value to growth– From micro-cap to large-cap– Sector– Theme

• International/World funds– Global– International (non-U.S.)

– Regional and country

2–15

Equity Fund Objectives

A g g ress iveG ro w th

C a p ita lA p pre c ia tion

E q u ityIn com e

G ro w th G ro w tha n d Incom e

In te rn a tion a l/F o re ign

S e c to r/S p e c ia lty

S m a llC o m ap a ny

W o rld /G lo b a l

E q u it F un d O b je ctives

2–16

Competitive Universes for Stock Funds

• For all equity funds– Morningstar sets broad categories and assigns

star ratings within categories– Morningstar sets narrower peer groups and

assigns category ratings within each group– Lipper categorizes fund around standard

investment objectives for return comparisons

• Primarily for U.S. general equity funds—based on historical holdings– Morningstar uses style boxes to rank funds– Lipper uses style classifications to rank funds

2–17

U.S. General Equity Funds Investment Style Classification Schemes

Morningstar StyleMapSM Lipper Style Box Classifications

Reprinted with permission.

2–18

Morningstar StyleMap

• Market Cap – weighted median market cap of fund’s holdings

• Styles are based on: P/E, P/Book and dividend yield (D/P)

• Growth : High P/E, high P/B, and low D/P.• Value : Low P/E, low P/B, and high D/P• Blend : Mix of growth and value; falls middle of

growth/value scale• Historical Vs. Current style.

2–19

Lipper Style Box

• “Old” system: Investment objective and market cap measured at the time fund purchased securities

• “New” System: considers actual fund holding regardless of objectives

• Classifies funds by analyzing financial characte-ristics of fund’s holdings at 3 different dates– Most recent portfolio (weighted 60%)– One year prior fiscal year (weighted 30%)– Two year prior fiscal year (weighted 10%)

2–20

Lipper Style Box

• Classifies funds as Value, Growth and Core• Examines P/E, P/B, and Sales growth• “Supper group”: all styles for a particular

capitalization• Differences between Morningstar and Lipper

– Multi cap and supergroup in Lipper– Market cap – Morning star uses 5000 stock index;

Lipper S&P SuperComposite 1500 index

2–21

Hybrid Funds

Hybrid Funds:• Invest in both stocks and bonds,• May also invest in convertible bonds and

preferred stocks,• Generally less risky than the stock funds; may

provide better return than the bond funds• The level of risk depends on the mix of stocks

and bonds,• Appropriate for conservative investors.

2–22

Hybrid Funds

F le x ib le

F ixed

A sse t A llo ca tio n Fu n ds B a lan ced Fu n ds

C o rpo ra te B o nd

P re fe rre d S to ck

C o n vertib le S e cu rit ie s F u nd

H yb rid F u n ds

Three types of Hybrid Funds:

2–23

Asset Allocation

Asset Allocation: Purpose is to put assets together in such a way as to maximize return at a level of risk consistent with investor’s objectives.

Process involves 4 key elements: 1) Investors need to determine the assets that are

eligible for the portfolio.2) Necessary to determine E(R) for these eligible

assets over a holding period.

2–24

Asset Allocation

3) Once returns have been estimated and risk accessed, optimization technique is used.

4) Choose portfolio from efficient frontier, provides maximum return, minimal risk.

2–25

Approaches to Asset Allocation

Fixed Weight: Fixed percentage of the portfolioto each asset category – 3 to 5 in total. Fixeddoes not mean equal weight.

Common Stock 30%Bonds 50Foreign Securities 15Short term Securities 5 Allocation does not change over time, may be adjusted

after a major market move to keep the desired fixed allocation

2–26

Asset Allocation

Flexible Weight - also known as strategic asset allocation: Weight changes on the basis of market analysis. Favorable domestic inflation forecast compared to foreign may result in revised allocation.

Common Stock 30% to 45%Bonds 50 to 40Foreign Securities 15 to 10Short term Securities 5 to 5

Weights are changed to capture greater returns in changing market.

2–27

Asset Allocation

Tactical Asset Allocation: Form of market timing that uses stock index futures and bond futures to change a portfolio’s asset allocation.

Stocks are forecasted to be less attractive than bonds, sell stock index futures and buy bond futures.

2–28

Asset Allocation

Bonds are forecasted to be less attractive than stocks, buy stock index futures and sell bond futures.

Requires sophisticated technique, large portfolio, quantitative modeling.

Appropriate for large institutional investors.

2–29

Balanced Fund

Balanced fund: Preservation of capital is the main objective

• Each fund sets its own fixed allocation percentage and discloses them in the investment objective,

• Traditional balanced fund allocation:– 60 % stock; 40% bond bond;– Other allocations scheme may be: 555% stock; 35%

bond; and 10% cash equivalent.

• Rarely the leading performers not the worst performer.

2–30

Convertible Securities Fund

Invests in corporate bonds and preferred stocks that can be converted into common stocks

• The majority of the bond and preferred stock are investment grade securities

• Small percentage may be invested in nonconvertible corporate bonds, U. S. government securities, foreign securities, and common stocks,

• Fund is not well known or popular; difficult to understand how the underlying instruments work.

2–31

Active versus Passive Management

• Actively managed funds– Goal is to outperform a benchmark index

– Managers attempt to add value through security selection and/or sector weighting

• Passively managed funds– Goal is to match the return of an index

– Managers may purchase all component securities of an index or a representative sample

2–32

Active versus Passive Management (cont.)

• Which is better?– There is much academic debate, with evidence on

both sides

– EMH adherents and some studies argue that active managers do not outperform over the long-term and that higher fees wipe out any difference

– Supporters of active management and some studies argue better success over shorter time periods, in less liquid markets, in “broad” markets, and with very talented fund managers

2–33

Alternatives to Mutual Funds

• Alternatives to equity index funds

– Unit investment trusts (UITs)

– Exchange-traded funds

• Pooled vehicles primarily for high-net-worth clients

– Hedge funds

– Common trust funds